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Housing
Index May Spell Trouble For Stocks
by Chris
Ciovacco
September 19, 2006
EXECUTIVE SUMMARY
- The correlation
between a weakening housing market and the stock market suggests
that a defensive investment stance is prudent at the present time.
- While the recent
advance in stocks is impressive on the surface, a more detailed look
yields some cause for skepticism.
- History tells us
that the probability of the Federal Reserve being able to engineer a
soft landing in the housing market is very low.
- The economic
impact of the recent housing boom has been greater than even the
largest stock market booms. It will be difficult, if not nearly
impossible, to replace this economic activity from another sector of
the economy.
- Since the interest
rate cycle should be similar to what followed the Interest bust, a
detailed review (see charts on page 2) of asset class and investment
performance between March of 2000 and October of 2002 can help
investors make better decisions should the stock market peak in the
near future.
- Since history
rarely repeats itself in exact form (especially in the financial
markets), it is also prudent to look at some possible differences
between the previous cycle and our current environment.
Housing Has A Strong
Correlation To Stocks
As shown by the National
Association of Homebuilders (NAHB) Homebuilders Index (see blue line in
chart above), the slowdown in housing has now reached significant
levels. NAHB produces the Housing Market Index (HMI), a weighted,
seasonally adjusted statistic derived from ratings for present
single-family sales, single-family sales in the next six months, and
buyer traffic. A rating of 50 indicates that the number of positive or
good responses received from the builders is about the same as the
number of negative or poor responses. Currently, the weighted rating is
firmly in the negative camp at 32. This represents a pessimistic outlook
for real estate in the next six months, which in turn is not good for
stocks. The chart above was taken from a report by David Rosenberg,
North American economist for Merrill Lynch. Mr. Rosenberg comments on
how the weak housing market may affect stocks:
"The chart
above is rather intriguing - the NAHB homebuilders index leads the
S&P 500 by 12 months and with a near-80% correlation - a correlation
that over time has actually strengthened, owing to the growing influence
that the real estate market has exerted on the overall economic and
financial landscape over the past five years. In fact, we can trace
almost two-percentage points of the 3 1/2% average annual rate in real
GDP over that time frame to the boom in housing construction and home
prices - the direct impact on homebuilding, the spin-offs to other
sectors like real estate services, architecture, engineering, legal, etc
and the multiplier impact from the 'wealth effect' on consumer spending,
especially on home improvements and household furnishings."
The statement above
means that during the past five years housing has either directly or
indirectly accounted for 57% of economic activity. The latest release of
new home sales shows a 21% year-over-year decline (view
PDF report).
Using the 12-month
lag of the S&P 500 as shown in the chart above, the actual
correlation between the S&P 500 and the homebuilders index is .79,
which would give us the following calculation to forecast where the
S&P 500 may be 12 months from now (roughly August 31, 2007):
- The homebuilders
index had a reading of 67 in August of 2005 (12 months ago)
- The reading of the
index as of August 2006 is 32
- A move from 67 to
32 represents a 52% decline
- With a .79
correlation to the S&P 500, we need to reduce that decline by
79%, which gives us roughly 41% (reduced from 52%)
- If the correlation
holds, which it may not, the S&P 500 would be 41% lower 12
months from now (or roughly on August 31, 2007).
That is a sobering
stat. While I am not forecasting that the S&P 500 will be 41% lower
a year from now, I am in the camp that believes it is prudent to take a
more defensive posture with our investment portfolios. This is a
correlation that cannot be ignored by investors.
It is also
interesting to note that the last intermediate peak in the homebuilders
index was made in October of 2005. This means according to the 12-month
lagging correlation the S&P 500 would hit an intermediate peak
sometime in or near October of 2006. As the chart below illustrates,
most recessions have been preceded by a period where housing prices
decline (prices shown are adjusted for inflation - recessions are shown
by shaded areas).
The Recent Advance
In Stocks Is Suspect
While the recent advance
in stocks is somewhat impressive, the statistics below the surface paint
a picture which warrants concern about the sustainability of the rally.
We have not seen figures in volume, new highs vs. new lows, common
stocks vs. preferred stocks, etc., that produce a favorable risk/reward
profile for taking substantial risk in the general stock market at the
present time. Dr. John Hussman covers this topic in more detail in his
article "A House Built On Sand", which contains the two
informative charts below (my comments have been added to charts):
The U.S. stock market
has gone over three years without a 10% correction. This has happened
only three other times in modern market history. The average decline
after the previous three runs was over 18%.
It Will Be Hard For
The Fed To Bail Out The Housing Market
We are all hoping for
the proverbial soft landing in housing, which in turn would enable a
soft landing to take place in the economy as measured by GDP (the value
of all good and services produced in the U.S.). If we use the boom in
Internet stocks as a proxy, it is difficult to assume we will get the
soft landing in housing. The chart below, taken from an August 2005
article in Forbes magazine, shows the Internet boom and the housing boom
side by side. Fueled by low interest rates and thus cheap access to
credit, the similarity between the two booms is striking.
Once the Internet
bubble started to burst, the Federal Reserve tried to engineer a soft
landing by cutting interest rates 11 times in just 12 months, moves
which are still without precedent today. Despite this aggressive action,
we all know that the proverbial soft landing did not occur in the
Internet space. The bond market's recent gains in price are signaling
that the Fed may be lowering rates in the future in an attempt to slow
the tide of the housing decline.
The media and Wall
Street are always hoping for the soft landing or "Goldilocks"
economic scenario. Unfortunately, the odds are stacked against having a
soft landing after a series of interest rate hikes. During the last 16
interest rate cycles, there has been a grand total of one soft landing
(see 1994). Using this one historical fact, there is a 6.25% (1/16th)
probability that we get a soft landing. With these odds is it worth
taking on too much risk with your hard-earned investment dollars?
The Economic Impact
Of The Housing Boom
Economic gains in the
United States in recent years have relied heavily on the rapid
appreciation in the housing sector. According to a report on housing
from Scotiac Capital:
Consumer
spending on furniture and household equipment has grown at more than 3½
times the pace of the overall economy during the current expansion,
accounting for a 14% share of overall growth (nearly three times its
share of the economy). Growth in residential investment has been double
that of the overall economy during the same period, accounting for 10%
of overall growth (compared with a 5% share if the economy). Finally,
the construction, home improvement, and real-estate related sectors
accounted for nearly 20% of overall private sector job creation in 2004
and 2005, double their share of private sector employment. Considering
the amount of housing-related stimulus the economy has enjoyed in recent
years, we expect a noticeable deceleration in the pace of real GDP
growth over the forecast period from the +3½ average of the past
three years to something closer to +2½.
Forbes makes an
argument that the overall economic impact of the recent housing boom is
greater than the largest ever stock-related booms:
"The total
value of residential property in developed countries has increased from
$40 trillion to $70 trillion over the past five years (8.2000 to
8.2005), which (as The Economist points out) represents a larger
potential bubble in terms of equivalent gross domestic product than
either of the stock market bubbles of 2000 or 1929.
The Current
Environment - Similarities & Differences To 2000-2002
Since housing is such an
important contributor to our economic well being, it is safe to assume
that the Federal Reserve will attempt to engineer a soft landing just as
it did after the Tech bust began in 2000 (read the Fed will lower
interest rates). With the current readings of inflation, it is also safe
to assume that any rate cutting campaign may have to be shorter in terms
of calendar days and lesser in terms of degree. The Fed will have
trouble taking rates as low as they did in the last economic slowdown
since lower interest rates tend to feed inflation. While the next rate
cutting cycle may look different and the global economic picture is
different than it was in 2000, we can still benefit from reviewing
economic and investment trends from 2000 to 2002.
When global
investment markets peaked in early May of this year, we did not have as
much evidence of a possible future economic slowdown as we do today. For
example the NAHB's Homebuilders Index was still above 50 as of April 30,
2006, which means builders were split about 50-50 on the outlook for
housing the next six months. As a result, there were much better odds in
May that the investment landscape would remain similar to the one that
had been present in the last 12 months (commodities strong, emerging
markets strong, etc). That is no longer the case.
Commodities and
emerging markets did rally off their June lows, but that rally may be in
jeopardy as market participants have more fully embraced that the
economy is slowing. The market's recent interest in more economically
sensitive issues seems to have some questionable circular logic. Here is
my read on what the stock market is forecasting in the next 6 to 12
months:
- Slower economic
growth which will lead to...
- A reduction demand
for commodities such as oil (this makes sense)
- Lower oil prices
mean more discretionary spending and a stronger than expected
economy (or a less severe slowdown)
But, doesn't a
stronger than expected economy or a less severe slowdown mean that the
demand for commodities (mainly oil) will also be stronger than expected?
If so, doesn't that eventually take us back to where we were in early
May with a strong economy fueling the demand for commodities, which in
turn is helping fuel inflation?
The economic evidence
seems to suggest:
- Slower economic
growth maybe slower than many are prepared for in terms of their
investment allocation. It seems the stock market has underestimated
the probable negative impact of housing on economic growth
- A slowdown in the
demand growth rates for oil and commodities in general, but not a
move to negative growth rates or a reduction in demand from present
levels for any significant period of time. The more likely outcome
is that energy demand growth rates will remain positive, but
experience a slowing in their positive rate of growth. For example,
if you assume energy demand is growing at an average annual rate
2.4%, we may see that figure soften to a growth rate of 1.7% per
year during an economic slowdown. With billions of new people in
Asia moving to a more energy intensive lifestyle, it is hard to
forecast declining demand for energy for any significant period of
time. In terms of investment, energy and commodities still appear
attractive long-term, but they may not perform well in the next 12
to 18 months as the markets price in a slowing economy. Whether or
not demand for commodities really slows significantly, the important
thing here is that the perception is that the demand will slow.
After a bull market correction, which could be significant,
commodities should benefit from a continued expansion of credit and
the money supply (especially if the Fed is forced to lower rates
sometime in the next 3 to 9 months).
- More persistent
inflation than the markets have currently priced into stocks. An
inverted yield curve (when a 2-year CD pays the holder more interest
than a 5-yr CD) has historically produced above average short-term
inflation pressures. There is also a meaningful correlation between
government spending and inflation. Inflation is more prevalent in
periods where the government spends more then it collects. This is
the situation that we have today.
- A possible return
to stagflation which was last experienced from 1973 to 1982.
Stagflation is a period of above average inflation rates accompanied
by slower economic growth (see charts below). During the previous
stagflationary period, commodities significantly outperformed both
stocks and bonds.
- Below-average,
inflation-adjusted returns for U.S. stocks. Stocks may rise in
nominal terms, but vs. gold, the world's true currency, the returns
may not be significant.
The charts below help
illustrate several important points:
The commodities bull
market is most likely not over, but it may experience a significant
correction and/or period of consolidation. Both gold and a diversified
basket of commodities experienced strong gains from 1972 to 1975, which
is similar to what we have seen from roughly 2001 to 2006. While the
bull market was far from over, commodities basically went sideways
(consolidated) from 1975 to 1977. We can see a similar consolidation in
gold during the same period. From 1977 to roughly 1980, the bull market
in gold resumed and rewarded investors who better understood long-term
market cycles. In a similar manner, a diversified basket of commodities
also reverted back to bullish mode from 1975 to 1982
At the present time,
it may be prudent to lighten up on some of your exposure to gold.
Slowing economic growth and the perception that slower growth always
leads to lower inflation (not always the case) will continue to create a
period where gold may lose some of its appeal as an inflation hedge.
However, as economic weakness picks up and the market begins to sense
that the Federal Reserve may be closer to lowering rates, the appeal of
gold will again start to increase as investors realize that any lowering
of rates by the Fed will increase downward pressure on the U.S. Dollar.
The true appeal of gold is that it offers protection from paper
currencies that can be debased by governments. We still like gold very
much in the long run, but also must acknowledge the case for possible
weakness before the next major leg up. As the chart above shows, there
can be painful corrections in a long-term bull market.
In a similar vein,
commodities also remain very attractive on a long-term basis, but they
may continue to come under pressure as long as perceptions remain that
growth is slowing and the Fed may not be done raising rates. Commodities
will become more appealing once the Fed signals that rate cuts may be in
the cards. As the chart below shows, much like gold, commodities in
general also may experience a period of consolidation before resuming a
long-term uptrend.
Details Of The Last
Economic Slowdown 2000-2002
If we are entering a
period of slower economic growth and declining asset prices (housing),
we may experience a similar economic and investment cycle that was
present after the S&P 500 topped in March of 2000. Stocks did not
bottom until October of 2002. In order to become further prepared for
economic weakness, I recently took a more detailed look at investment
performance from March of 2000 to October of 2002. I broke this period
into six sub periods where investors varied their economic outlook from
positive to negative and then back to positive again. The phases look at
how the financial markets react to moving from economic expansion to
slower economic expansion (or recession), and where the Federal Reserve
is transitioning from a rate raising cycle to what eventually becomes a
rate lowering cycle.
Before we make some
comments about the charts below, it is important to mention that
economic cycles and market reactions rarely, if ever, follow historical
patterns in the exact same way (timing, magnitude, and correlations
always shift in some way). As an investor, you must balance history with
current market conditions and always listen to what the current market
is telling you. Said another way, no matter how compelling a bullish or
bearish case you have in hand, never stubbornly hold on to any beliefs
in the short run. The market may be seeing things that you have missed.
Your confidence should rise when your opinion or forecast starts to be
confirmed by market activity. It can be very expensive to invest based
on what you think the market should be doing vs. what it is actually
doing.
Based on my research,
I feel we are approaching the end of Phase I. Phase I most likely began
in today's market in early May 2006. Phase I in the year 2000 began when
the S&P 500 topped in March of 2000. Phase I is a feeling out
process where the market is unsure of how much growth is going to slow,
and if the Fed is done raising rates yet.
In the year 2000,
Phase I took 153 calendar days to complete. In 2006, if we assume that
Phase I began on May 5, 2006, then 153 calendar days would take us to
October 6, 2006 (roughly two weeks from now). I would not put too much
stock into that date, but it tells us that Phase I of the current cycle
may be getting close to completing.
Since I believe Phase
I is almost over or should complete sometime in the next 30 to 60 days,
I want to focus our attention on Phases II thru XI with an emphasis on
Phases II and III.
The chart above shows
Phase II (once stocks shift to a long-term down trend) to Phase VI
(where the stock market bottoms in anticipation of the next expansionary
cycle). The winners in the previous economic slowdown where gold stocks,
hedged stocks (via options or shorting), long maturity bonds, physical
gold, short maturity bonds, and foreign real estate. Since we all hold
U.S. real estate, our analysis focused on real estate outside the U.S.
The investments that performed poorly during Phase II through Phase VI
were most stocks (foreign and domestic), including oil stocks.
If you are wondering
how a diversified basket of commodities performed from Phase II to Phase
VI, the answer is much better than the S&P 500, but basically flat
(it was up roughly 1.04%).
Phase II (chart
above) is when the market really starts to acknowledge that the economy
is slowing (maybe more than most had planned for) and the odds are
increasing that the Fed is done raising rates. Stocks become weak after
the focus moves off the Fed and shifts to future corporate earnings and
a weakening economy. On the long side, bonds provide some cover, but
only short sellers of stocks or those who have hedged stock positions
(using options contracts) perform well during Phase II.
We have not yet
entered Phase II where stocks have topped, but it is prudent to at least
have a plan in place to migrate to should we enter Phase II sometime in
the coming weeks or months.
Phase III (see above)
shows that even after we have started a downtrend for stocks, there will
be several false rallies as stocks continue to make lower and lower
lows.
The Obvious Wildcard
- Inflation
Inflation is the
greatest variable that will most likely change the way the current cycle
evolves vs. what happened from 2000 to 2002. If inflation is already in
check, then the results of the previous cycle will be a more accurate
proxy for what may happen in the next 6 months. On the other hand, if
inflation continues to be a problem, it may force the Federal Reserve to
initiate further interest rate hikes. This scenario would put into
question the safe haven status of bonds until the Fed can get inflation
under control.
What Does It All
Mean?
We are still uncertain
if the Fed is finished raising rates or if the major stock market
indicies have already made significant highs for the cycle in May of
2006. As a result, it is important to keep an open mind concerning how
the next six months may play out. I feel the evidence is compelling
enough to begin reducing exposure to assets that did not perform well in
Phase II of the year 2000 cycle (shown on charts above). You may also
want to increase your exposure to bonds. With the uncertainty associated
with the Fed, a mix of shorter and longer maturity bonds may be prudent.
Parking some money in a money market may not be a bad idea either. It
will give you an opportunity to see how things play out in the next 30
to 120 days while earning an easy 5%. Taking a more conservative view of
how gold and a basket of diversified commodities may perform in the next
6 months may also be a good idea. With the government in significant
deficit spending mode, inflation may be with us for quite some time,
which means a stagflation portfolio may have appeal after Phase II has
completed. This may also be an excellent time to consider doing some
research on possible ways to hedge your U.S. stock positions. This can
be done with options or via selling short. This may take the form of a
very small portion of your assets; say 5% to 10%. This small position
can help hedge other positions from possible weakness.
Chris Ciovacco is the
Chief Investment Officer for Ciovacco Capital Management, LLC. More on
the web at www.ciovaccocapital.com
© 2006 Chris Ciovacco
Editorial
Archive
CONTACT
INFORMATION
Chris Ciovacco, CIO
Ciovacco Capital Management, LLC
Atlanta, GA USA
Email l Website
Chris
Ciovacco is the Chief Investment Officer at Ciovacco Capital Management,
LLC. More on the web at www.ciovaccocapital.com
The
opinions of FSU contributors do not necessarily reflect those of
Financial Sense.
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