Take a quick walk with me down "flashback lane." The year is 2004. Homes, by most measures, are no longer affordable. Yet home prices did not peak until two years later in the early months of 2006.
The stock market, a forward-looking beast, tends to recognize bad (and good) trends roughly six months in advance. Not surprisingly, then, one of the premier homebuilders, Toll Brothers (NYSE:TOL), catapulted roughly 200% from $20 per share to $60 per share between the start of the bubble in 2004 and mid-2005. Toll Brothers then spent the next six months depreciating 50% in value as it dropped back down to $30 per share; it made it to $20 and below by the end of the real estate collapse in late 2008.
Back in the present, homes are once again stretching the boundaries of affordability. With a little help from John Carney, CNBC, and the folks at the the St. Louis Federal Reserve bank, one can see that housing has crossed below its long-term trend on affordability for the first time since 2004. Does that mean homes will depreciate in value tomorrow? Not likely. Real estate didn't hit its maximum price capacity until 2006 and the bubble didn't really pop until 2007. Does this mean that homebuilder stocks are about to get crushed? Not necessarily. Toll Brothers ran up 200% from the onset of a downtrend in affordability to 6 months prior to the peak in home prices.
Indeed, the SPDR S&P Homebuilder ETF (NYSEARCA:XHB) appears to have found solid support near its 200-day moving average. Moreover, there appears to have been an ample number of tests near $28 per share for XHB; in every instance, XHB has bounced higher.
Clearly, the U.S. Federal Reserve's upcoming decision on the future of monetary policy (Sept. 18) is crucial for stock investors. The recent upswing in funds like XHB and iShares DJ Home Construction (NYSEARCA:ITB), as well as a broader-based seven-day winning streak for the S&P 500, suggests that most expect the Fed to do little more than "save face" with a token amount of tapering. The Fed is still expected to provide as much bond buying with electronically created dollars (aka quantitative easing) at the same rate as QE2 from 2010-11.
On the other hand, what if the committee members vote in favor of waiting a few more months? What if they collectively decide that the economy is not genuinely strong enough for tapering just yet? What if Chairman Bernanke prefers to let a significant policy change be made by the incoming chairman, not himself? If tapering is put on hold entirely, the Fed would effectively be inflating a housing bubble some more, sending the 10-year Treasury yield plummeting back toward the 2.6% to 2.5% level.
If the Fed were to essentially insinuate that job data or the economy were not strong enough for the removal of a very modest amount of emergency bond buying, one should also expect a wave of confusion for most U.S. stocks. The exchange-traded winners would be the interest-rate-sensitive assets -- SPDR Select Sector Utilities (NYSEARCA:XLU), iShares Mortgage REITs (NYSEARCA:REM), Vanguard REIT (NYSEARCA:VNQ), XHB, iShares 20 Year Treasury (NYSEARCA:TLT), iShares Preferred (NYSEARCA:PFF), iShares 7-10 Year Treasury (NYSEARCA:IEF), etc.
Is it likely that the Fed will attempt to stand pat? It might be too difficult to achieve, considering how far the bond market has gotten out in front of the Federal Reserve. It is far more probable that they will taper by the smallest and most insignificant of amounts, hoping that bond yields refrain from climbing further while still bolstering stock market enthusiasm.
And then there's the most unlikely scenario of all -- but it is not beyond the realm of possibility. What if Fed Chairman Bernanke wants to make a more definitive statement prior to his exit? What if Bernanke sides with hawks who feel that "enough is enough" on the stimulus? What if, instead of trying to keep longer-term rates below 3% by emphasizing the need for ultra-accommodating monetary policy, committee members exclaim that labor trends and economic trends are actually showing signs of accelerating? And what if Fed members see the long-term trend on declining housing affordability, worry about creating yet another bubble, and subsequently decide that significant tapering is needed to keep mortgage rates closer to 5% than 3.5%?
Most investors would be deterred by "large-scale taper" when most are expecting "taper-lite." A sell-off for broader U.S. stocks would be in the cards. Bond yields might surge, creating price depreciation across the income spectrum as well. The exchange-traded winners would likely be short positions such as ProShares Short Dow 30 (NYSEARCA:DOG) and ProShares Short S&P 500 (NYSEARCA:SH), as well as Ultra Short 7-10 Year Treasury (NYSEARCA:PST) and Ultra Short 20 Year Treasury (NYSEARCA:TBT).
Again, investors are likely to get what they are expecting here: a light peppering of taper around a meager 10% ($8.5 billion) of the $85 billion. Bonds might gain (yields decrease) on a "buy the rumor, sell the news" event. Stocks might rocket ahead at first, but they would likely come back down to earth with debt ceiling debates and earnings warnings on tap. Nevertheless, there are ETFs if the Fed goes against conventional wisdom, whether it encourages the "housing recovery" by shelving the tapering discussion, or whether it squelches speculative real estate altogether with an unusually large decrease in the amount of bonds that they purchase.
Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.