Deflating Housing Bubble = Comfy Landing for Equities

by: Philip Davis
Money, money, money!

Where does it come from? Where is it going?

For the past 3 years, a lot of America's money has gone to just 2 places -- oil and homes!

As we discussed last weekend, over $2.5T has poured into the commodity markets in the past 36 months, but that's nothing compared to the $12T that been added to the value of U.S. homes in the past 3 years alone.

The median price of a U.S. housing unit has climbed from $143K in 2003 to $239K at the end of 2005. With close to 7M homes a year turning over, that's $1.9T in 3 years of new money that has worked it's way into housing and, unlike the oil we bought, we still have the house!

If housing "stock value" drops 25% over the next 3 years, that would mean that 21M new homeowners would have lost $500B of the capital they invested (assuming they aren't forced to "close their positions" on the homes), while a 25% drop in commodity stocks wipes out over $1T in real value since ExxonMobil Corp. (NYSE:XOM), for example, turns over all of its 5B shares in 227 days of average trading.

According to the 2005 U.S. census [pdf], 17% of our country's 125M housing units were occupied for one year or less (roughly 30% are rentals). Assume a similar number in 2004 and 2003, and that's a turnover of almost half the U.S. housing in just 3 very expensive years!

I think if you look at it from that perspective you could say that pretty much everyone who wanted to move has done so by the middle of this decade (page 90). From 2000 to 2004 9M new units were built (pg 17), a far cry from the 14M that were built from 1975 to 1979 -- that was real overbuilding!

In fact, from 1970 to 1980 an average of 2.5M units a year were built compared to just 1.8M per year from 1995 to 2004, the current "Housing Bubble."

What kind of slump hit us after that development boom? In the next 5-year period, from 1980 to 1984, just 7.5M (1.5M/yr) new units were built! Now that's a correction!

The slowdown started in 1979, and 1980 was the last year of Carter's term in office, the Iranians were holding U.S. hostages, and oil and other commodity prices were sky high. We switched Presidents in November, but the markets were already up 15% for the year -- even during the "horrible" Carter administration!

How did the market do from 1980 to 1984? Well, like Bush, the Reagan tax cut was an initial disaster for the economy, and the market lost 20% between Jan 1981 and April 1982, but Reagan was smart enough to realize his mistake and actually approved several tax increases to stop the bleeding and, from April 1982 to Jan 1987, the Dow climbed from 785 to over 2,000, a level it held after spiking to 2,700 in July.

Our current "housing bubble burst" may be effectively a non-event in the U.S. and may, in fact, usher in a new round of equity buying as a portion of the $30T tied up in 125M homes finds its way into the market, rather than going into more expensive homes, as it has been for the past 5 years.

In 1980, mortgage rates were roughly 15% and people were literally forced to sell all the speculative homes they bought at fire sale prices -- a far cry from being "stuck" with a $100K loss on a 7% loan.

Even so, a person selling the same house this year, even for less money, may end up with more free cash to spend than a bubble buyer!

The Bubble Buyer:

Let's say, in last year's bubble market, you bought a house in 1995 for $300K and last year it sold for $500K.

You made $200K on the transaction, less $15K to the realtor. Let's say you had 25% equity built up, for another $75K, so you have $260K to put towards your new home.

Since it is unlikely that your participated in the real estate bubble out of necessity let's assume you were moving up to a nicer home, say $650K:

Your new deposit is $65K, moving in and out expenses are $15K, and your new mortgage plus taxes is about $22K per year more, so that $155K profit you made wouldn't feel like a lot of free money.

Today's Buyer:

As we can tell from the inventory reports, nobody is anxious to sell their homes at a loss. We can assume the majority of people selling are doing so because they really have to, not much for fun anymore.

Let's say the 1995 house that was still bought for $300K, still has a $225K mortgage ($2K a month with tax), and today's buyer is forced to sell it for $450K. After paying the realtor $23K and the in-and-out expenses of $15K, that's still $187K left to spend.

If today's buyer is seeking a more modest or similar home (since they are moving out of necessity rather than greed), let's say a nice $500K home, they will require a $50K deposit, but their forward mortgage and tax payments will be virtually unchanged, making the $137K remaining in the bank seem a lot more like free money!

They have effectively released $137K of savings they have poured into their home over time, and, if they still have their job and expenses don't change much, that money is now free to join the "regular" economy.

That brings us back to the Consolation Prize Theory, just like the rich people who didn't move at all and used the money they didn't spend to buy luxury goods, furniture etc for the home, today's buyers who make a more modest move with can afford to splurge a little.

Another thing today's buyer will do (and this is all assuming that we are not in a job-loss/ wage-loss environment) is gamble a little in the market! With 7M homes turning over annually and the median home gaining (even after this year's drop to $220K) a median of $70K, that's $500B deposited in U.S. savings banks. If just 40% of that money finds it's way into mutual funds or stocks, that's a $200B market infusion of cash per year!

Of course, the number is much higher than that, as you can imagine the difference when you apply these numbers to the nation's wealthiest 20%, who hold 80% of the real estate and are the most likely to play the market with cash in the bank.

Combine this $50B a month in money coming into the market from homes with a similar amount working its way out of other commodity stocks, add $13B a month consumers can spend on things besides gas when oil is down $20 a barrel, and you have the recipe for a very, very, soft, comfy landing!

It could happen!

Read all of Phil Davis's articles on Seeking Alpha.