Whose Fault is it anyway?
12/31/08
A Financial Times poll, conducted among 6,165 adults in France, Spain, Germany, Italy, the UK and the US indicated that some 70% of the Spanish and two-thirds of the French agreed "strongly" or "somewhat" with the statement that the Euro could overtake the dollar in global importance by 2014. For Germans and Italians the figures were 58 per cent and 62 per cent respectively. Even some 48 per cent of those polled in the US agreed. The reason for this believe of course is obvious. The decline of this old empire was not only wished for by Osama bin Laden. Many Europeans are also convinced that the days of US hegemony are (and should be) numbered. That impression of course is understandable. A tongue-tied President whose incompetence is only surpassed by his arrogance, a war in two countries that is stumbling into its 6th year without ever having come close to capturing Osama bin Laden and a mortgage securitization process on Wall Street that by all accounts had no integrity left to speak of are some reasons for this perception. The empire was brought to its knees by its own hubris. Or was it? Let us put all wishful thinking aside and let's look at some pertinent facts. Our Presidents (past and future) and the merits of waging war on countries belong firmly in the categories of opinion and are therefore best left out of this. It all started with the housing market and the mortgages that those houses collateralized. The housing market as measured by the Case-Shiller index on home prices was down 18.04% on a year-over-year basis in October vs. -17.39% in September. The year-over-year decline in the Case-Shiller index stands in sharp contrast to the 7.5% decline reported by the Federal Housing and Finance Agency (FHFA) for the month of October. The reason for this is simple: The Case-Shiller index is based on 20 metropolitan areas only whereas the FHFA index is broader.
Home prices and new home sales continue to collapse. Overextended households and rising unemployment are taking their toll on real estate markets around the country. So far so bad and so far no new news. The empire is in decline and the world is watching while contemplating their own fate, which may not be much better. Europeans are deeply gloomy about the economic outlook, with less than a quarter believing that the recession will last less than a year, according to the above mentioned poll. So let's have a look at the housing markets in other countries and see if they are any more prudent or better off than the United States. OECD studies are often very detailed considering the logistical problems involved when trying to compare countries, markets and data collection techniques on an apples to apples basis. One summary measure commonly used to assess housing market conditions is the price-to-income ratio, a gauge of whether or not housing is within reach of the average buyer. If this ratio rises above its long-term average, it could be an indication that prices are overvalued. In that case, prospective buyers would find purchasing a home difficult, which in turn should reduce demand and lead to downward pressure on house prices. The ratio of prices to household disposable income by itself, however, is not a sufficient metric to evaluate housing affordability. Indeed, house prices do not appear to be linked to income by a stable long run relationship possibly because the cost of carrying a mortgage has varied over time. In fact, aggregate disposable income is likely not the appropriate denominator. It is an average measure that covers the whole population, whereas house prices are determined in a market where specific groups of sellers and buyers have different and likely higher incomes than the population mean. Another measure used to get an indication of over or undervaluation is the price-to-rent ratio (the nominal house price index divided by the rent component of the consumer price index). This measure could be interpreted as the cost of owning versus renting a house. When house prices are too high relative to rents, potential buyers find it more advantageous to rent, which should in turn exert downward pressure on house prices. During the recent upswing, this ratio has generally outstripped the affordability measure, hitting historical peaks in several countries.
Bot charts show three distinct groups. Countries high above the long term average of 100, countries somewhat above the long term average and countries below the long term average. Both charts show that price-to-income and price-to-rent ratios for the Netherlands, Spain, France, Denmark and the UK are between 40% and 100% above their respective long term averages of 100. The group with somewhat overvalued real estate markets consists of Italy and the United States. The group with undervalued real estate markets (relative to their long term averages) consists of Germany, Japan and Switzerland. This now becomes very interesting for the following reason. The countries with the most overvalued real estate markets are arguably the ones with the most overvalued collateral and therefore the ones with the shakiest mortgages and thus the most vulnerable banking system. It seems that the bad habits of overindulgence, decadent lifestyles, reckless borrowing and irresponsible lending are not confined to the "kingdom of decadence" as many Europeans thought. By god, some Europeans are even more addicted to debt than the USA.
Just in case you missed it. What I am trying to say is that the Euro currency is in greater danger to disappear by 2014 than the US Dollar is to be overtaken by the Euro. Don't kid yourself. Europe is the one with the structural problems. The Euro was good for investment purposes while the going was easy. Now that times are getting tough it will become more and more difficult to keep the weak countries from financing their bailout and stimulus packages on the back of other EU members. The Euro is only as strong as the political will and financial stability of the sum of its member countries. Italy and Greece will be tested severely soon. All countries with overvalued real estate markets will come next. Their banking systems are in grave danger of collapsing. I hope that Europe will be able to manage the coming crisis. I wish to see the 20th anniversary of the Euro, too. The greatest peaceful experiment among nations deserves to last longer than 10 years. Unfortunately, there are not many reasons to be optimistic. However, what I can guarantee you is that the US dollar will not disappear and the aging, decadent empire of ours may well surprise most people to the upside. In fact I am as bullish on America and on American stocks as I have ever been in my lifetime. Norm Conley has compared the Moody's BAA bond yields to 10-year treasuries. The yield difference has never been this wide. Check out the table inside the chart and you will understand what I mean. Since 1926, if one had invested in the S&P 500 only when the BAA/Treasury yield ratio was declining, one would have realized an annualized return of almost 18%. On the other hand, if one had invested in the S&P 500 only when the ratio was rising, the annualized return would have been a miniscule 1.34%. If your investment time horizon exceeds one year, you should be extremely bullish too.
Hermann Vohs
"Be always at war with your vices, at peace with your neighbors, and let each new year find you a better man"
Benjamin Franklin
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
