This Housing And Stock Market Rally Is Government-Induced And Can't Be Trusted

Includes: CAT, GE, RDN, SPY
by: Trade In Mexico

Many investors seem to be convinced that we have a perfect "Goldilocks" situation, whereby the economy is so bad that the Federal Reserve will have to keep supporting it with extremely low interest rates and asset purchases. On the other hand, the economy is good enough for the stock market to rally further and further. I just don't buy it, and something is going to give. There appears to be a number of divergences that indicate that the recent optimism in housing and the stock market are maybe not warranted.

The training wheels have been on for years, and even so, the economy appears unable to maintain a strong pulse without constant government intervention. The market might be starting to clue into this fact and to the reality that the market simply doesn't deserve to go up indefinitely when so much of the support for the housing and stock market is based on government policy. There are signs the market is topping out. Just look at General Electric (NYSE:GE), Caterpillar (NYSE:CAT) and other industrial stocks that should be leading the market, not lagging it. Caterpillar recently announced a sharp drop in sales of about 26% in Asia and even a 12% drop in North America where the new "housing boom" is taking place. General Electric shares have been lagging the market rally and appear stuck at the $23 range. Those are two major industrial stocks, and the weak price action could be sending a message that a multi-year economic recovery is not on the way.

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By looking at the S&P 500 Index (NYSEARCA:SPY) and nothing else, you might think that the economy is booming, unemployment is low, the global economy is stable and at low-risk of having another financial crisis. However, unemployment remains stubbornly high and the official number would be even higher if so many people had not just given up on trying to get a job. A record number of Americans are collecting welfare today, and the U.S. Government debt load is also at record highs. This is hardly the data that creates a sustainable, long-term rally. If it weren't for the Federal Reserve's constant and massive support for the economy, things would look quite different. What we are really seeing is artificially low interest rates and other policies that are being used to manipulate the stock market and housing.

This means the stock market and housing are not going up for the right reasons, and you have to wonder what happens when the Federal Reserve pulls out or is possibly no longer able to manipulate the economy through artificially low rates and other programs. What's really amazing is that even after years of easy money and a major stimulus plan, this economy still needs training wheels. Many investors and analysts seem to believe that the housing market has finally achieved "escape velocity". Just take a look at the massive rally in homebuilders and the mortgage insurance stocks, all of which are trading near 52-week highs and now look very overbought.

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Radian Group, (NYSE:RDN) shares were once viewed as a "toxic" holding by some not long ago, and the stock has surged from below $3 last year to over $10 recently. Jim Cramer of CNBC is calling the stock a "steal" even after it has more than tripled off the lows. Before you assume I am a "perma-bear", realize I am not into doom and gloom, just reality. I was bullish on one mortgage insurance stock, Genworth (NYSE:GNW). But I liked it back when it was trading for $4 to $5, and it has since doubled to trade over $10. It is hard to be as bullish now that the "herd" loves this sector and has pushed these stocks up so far and so fast.

While there is reason to believe in a slow and steady improvement in housing, I think these stocks have gotten way ahead of the fundamentals. We have seen "false dawn" hopes and rallies quickly dashed as the economy and housing have stumbled after showing signs of promise, and this could happen again. The biggest problem I see with the housing market is that it is going up because of government manipulation and because of speculation with investors once again making overbids and buying multiple properties. This is the same type of behavior that got us into the financial crisis. A really healthy housing market rally would be based on strong jobs growth and not on monetary policy and interest rate manipulation that was creating a situation where people who saved money would actually lose money year after year, when taking inflation and taxes into consideration.

Government programs that were designed to increase home ownership rates and make homes affordable ended up making housing out of reach for many in the last years of the housing bubble. Americans are so used to government housing programs that I don't even think many realize how much manipulation of the housing market exists. Here are some of the programs that I believe were used and are still being used to manipulate Americans into buying a home, which as we know, can eventually lead to a financial crisis:

1. The Federal Reserve has pushed down interest rates to artificially low levels. Responsible savers and retirees are paid next to nothing in savings and money market accounts, and this is designed to make anything "safe" as a very painful option, since saving money at current interest rates actually means you could be losing money after factoring in taxes and inflation. The extremely low rates helped to stabilize the plunge in home prices, but in time, it could just lead to another bubble popping when interest rates rise. As seen in some countries in Europe, governments can lose the ability to control interest rates, and higher rates could push home values down sharply.

2. Little to no money down loan programs. Let's face it, any loan program that allows borrowers to put down 3% or less than what the standard 5 to 6% commission is to sell a property, is ridiculous. In many states, borrowers can walk away from the property without recourse, and that leaves the bank and the U.S. taxpayer to foot the bill without even enough equity to cover the sales commission that would be needed to sell the property. Even after a massive financial crisis, low money down programs exist, thanks to the U.S. Government. Low money down loans allowed massive leverage, and in the end, this type of loan just pushes up real estate prices to what eventually becomes unaffordable levels.

3. Once you buy a home, you can deduct mortgage interest ,which is yet another way that the government ends up making housing "affordable." I would call this more manipulation of the housing market. The problem is that the affordability factor is diminished over time, because the mortgage tax deduction ends up increasing what each buyer can afford to pay each month. Another problem is that if the government ends the mortgage tax deduction, it could be devastating to the housing market. There are proposals by members of Congress to end the tax deduction as a way to raise revenues for the U.S. Treasury, because this country is deeply in debt. Take away the tax deduction, and that completely changes what a borrower can qualify for in terms of the loan. That could lower property values significantly. As we have seen, a big decline in property values can cause a major financial crisis and lead to massive bank losses. If this happens again, it is questionable to believe that the U.S. Government will be in the financial position to bail out the economy.

4. Once you have bought a home with an extremely low down payment, with the added benefit of very (artificially) low interest rates, and a monthly mortgage payment which is currently tax deductible, you could then sell your home and pay no tax on the gains of up to $250,000 if single, or a whopping half a million dollars, if married. This is just another way in which the U.S. Government is pushing up demand artificially and increasing speculation in housing. In the long-run, government programs to make housing affordable do not work, because these plans just end up arming other buyers with the same increased purchasing power that you have, and that pushes prices back up. But the government is not just doing this to be nice, it is doing it to try to pump the sagging economy up. Politicians set up these programs to boost the economy in the short-term, in order to get themselves or their party re-elected, even though it can (and has) hurt our country and economy in the long-run.

So, why should we be worried? Mainly because the U.S. Government appears too heavily involved in manipulating asset prices, whether it be stocks or real estate. Had the government not been so involved in making home ownership "affordable" through multiple programs designed to entice potential buyers, it is doubtful that banks would have made loans that require so little down. It is also doubtful that prices would have reached such unaffordable levels, especially if borrowers were required to put down 20% or more, which is required in a standard bank loan that does not have government backing. Take away the tax deductions and that would have put a serious damper on the massive price appreciation that was seen. In fact, if government really wanted to make housing affordable, it would pull out of the real estate market altogether. Just imagine how low home prices would go without all these programs.

That brings me to the final point, which is what will happen to stock prices when the government does pul lback from the housing market and from quantitative easing? The Federal Reserve is reportedly buying $85 billion per month in assets. That is huge. Many investors and analysts are rightfully concerned about what might happen to the stock market when the Federal Reserve ends the bond buying and other asset purchases. While it might be considered to have as much likelihood as a "Black Swan" type of event, if the Federal Reserve pulls out of this market too early or too abruptly, or if the mortgage tax deductions are ended, if rates rise, etc., the housing and stock market rally could end badly.

The U.S. Government has a balance sheet that has been stretched thin by wars, the financial crisis, out of control entitlement spending and other factors. This will minimize its ability to endlessly prop up this economy or to curtail another financial crisis with massive bailouts. What if the Emperor has no clothes? How much more time will the markets give to the Federal Reserve to truly get this economy firing on all cylinders? Will the bond markets turn against U.S. Government debt as was the case in Europe, before this economy turns? Those that believe the U.S. Government has infinite powers should be reminded that many felt the same way about Rome. Let's not forget that the U.S. Government has brought us a number of programs that many consider to be essentially bankrupt: U.S. Postal Service, Social Security, Fannie Mae (OTCQB:FNMA), student loans, Medicare, and others. That is quite a track record.

This won't keep me from buying stocks or even property, but I will do so with caution. Housing and market rallies that are significantly based on government intervention and policy support can't be trusted and could end badly. It appears to be a game of musical chairs, and it might last for a long time or it might not. The hope of the government policymakers seems to be that the entire economy can eventually reach escape velocity and that the Federal Reserve can pull out at the right time, while increased economic growth generates enough additional tax revenues to bring the debt levels back to more reasonable levels. That's the goal, and I hope it happens, but I think investors should remain prepared for policy missteps and other scenarios that might not let the "Goldilocks" scenario play out. I think investors who keep ample cash reserves around and who also sell into strength when markets are overbought (as is the case now), will do better than investors who remain fully invested.

The belief that everything is going to work out great seems too good to be true. For this housing and stock market rally to be trusted, real, and sustainable, it needs to be organic and based on jobs growth from the private sector, wage and productivity increases. Right now it is based on artificial government manipulation, that cannot last forever. So, enjoy the housing and market rally, but remember the reasons why this has been one of the least-respected and least-trusted market rallies.

Disclaimer: Data is sourced from Yahoo Finance. No guarantees or representations are made. Please consult a financial advisor before making investments.

Disclosure: I am long GNW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.