Although the stock market is giddy, the dire fundamentals have hardly changed. Housing is continuing its freefall and is beginning to impact the rest of the economy. A hard landing or recession that has not been discounted by the stock market remains a strong probability.
Pending home sales plunged 6.5% in August and 21.5% year-over-year to the lowest level since the inception of the series in January 2001. National Association of Realtors (NAR) economist Lawrence Yan stated "The impact was greater in the high-cost markets that are now dependent on jumbo mortgages. In some areas as much as thirty percent of signed contracts were falling through in August. The volume of activity we are seeing today is below sustainable market fundamentals because some credit-worthy people are trying to buy houses and they cannot." The Case-Shiller home price index dropped 3.2% year-to-year in the second quarter (before the credit upheaval), the largest drop in its 32-year history. Moreover the quarter-to-quarter decline has accelerated in the last three quarters to a 6% annualized rate in the second quarter.
The rest of the economy is deteriorating as well although it has not yet fallen off a cliff. Chain store sales have dropped 2.2% since late July with a large number of retailers indicating disappointing sales. A leading retail organization is forecasting the weakest holiday season since 2001. Although many observers are pointing to a strong labor market, this is certainly not the case. The year-to-year rise in payroll employment has steadily declined from 2.2% in April 2006 to 1.2% in August. In the past 50 years whenever the yearly rate of increase dropped to 1.4% or less, a recession has resulted in six of seven occasions. Tomorrow morning’s jobs report for September cannot change this trend as even a job increase of as high as 239,000 would still leave the yearly growth rate at a paltry 1.2%. Furthermore the outlook for capex is under pressure as well. Core factory orders were down 0.5% in August and off 1.8% for the year-to-date.
We see more trouble ahead as delinquencies on subprime mortgages are still rising, defaults are increasing at record rates and home prices are falling. Last year subprime and Alt-A mortgages accounted for 40% of the housing market, and few new ones are being issued today. With this much of the market demand virtually evaporating, the outlook is for even higher inventories and lower house prices in the period ahead. In addition rate resets, which have not yet been a big factor in subprime delinquencies, will be a major factor in coming months. Subprime loans are becoming due for resets in huge numbers at a time when restrictive regulations will severely limit refinancing possibilities. This means more distressed sellers and rising foreclosures. Since the typical subprime mortgage holder is paying almost half of his or her gross income on mortgage payments even at the teaser rate, restructuring these loans will be extremely difficult. In our view, therefore, the economy is faced with a continuing negative cycle of higher delinquencies, tighter credit and lower home prices.
We believe the market is basically ignoring the potential impact of the housing situation on the rest of the economy just as it ignored the impact of the dot-com collapse earlier in the decade and the subprime crisis itself as recently as a few months ago. Alan Greenspan, in his autobiography, admitted that he failed to see the impact of the housing boom while Bernanke and the Fed staff didn’t realize what was happening as recently as two months ago despite the fact that the Fed employs about 250 Ph.d economists, the largest such group in the world. The Fed along with the vast majority of economists and strategists has been consistently behind the curve in grasping the negative implications of the housing boom and its consequences. It is indeed puzzling why anyone would believe that they are suddenly ahead of the curve today.
