We at PCA have been bearish on San Diego housing for quite some time. One of our earliest concerns was that the rampant use of risky home loans, especially "teaser rate" loans that traded a low initial monthly payment for a potentially much higher payment down the road, would lead to extensive foreclosures if the borrowers' hoped-for home price appreciation didn't materialize. The inevitable fallout from all that reckless lending was one of the cornerstones of our long-held belief that San Diego would eventually experience a housing correction that surpassed the region's early-1990s real estate downturn in severity.
When we expressed these concerns, we were almost universally informed in no uncertain terms that foreclosures could never get as bad as they did in the 1990s unless San Diego experienced widespread unemployment.
Now that illusion has been shattered. Despite positive growth in local employment, San Diego homeowners are going into foreclosure at a faster pace than they ever did during the worst of the 1990s bust:
The point of this story is not to pat ourselves on the back. It is to demonstrate that investors, be they expert or layman, have a strong tendency to buy into what we call "stories." These types of investing stories typically have the following characteristics:
- They are widely believed.
- They are seldom questioned.
- They handily explain why the storytellers' desired market outcomes are sure to take place.
There is no shortage of stories floating around the financial markets today. Below, in no particular order, are some of the current favorites, along with brief synopses of why we think they will eventually be proven incorrect.
"Stocks are cheap." As we've discussed here before, the broad stock market only looks cheap if you ignore the fact that we are just coming off of a record peak in earnings growth, or if you pretend that profit growth will, for the first time ever, fail to eventually revert below its long-term average.
"Inflation is not a problem." This is a big one that deserves, and will eventually get, its own series of articles on pcasd.com. To summarize for now, this story ignores the facts that the Consumer Price Index is a very narrowly-focused measure of price pressures, that the "Core CPI" is even worse, that the CPI is calculated in a way that understates inflation compared to how it was calculated in the past, that monetary policy is being conducted in a way that has traditionally led to long-term inflation pressures, and that monetary policy is likely to become even more inflationary as the housing downturn worsens.
"Low interest rates justify high stock valuations." Well, there is some truth to this one in that lower rates do tend to be accompanied by higher valuations and vice-versa. But should low rates be accompanied by high valuations? It makes sense to think that lower rates would make future income streams more valuable, but the problem is that this analysis assumes that rates will stay constant, which they never do. As it turns out, valuations themselves are an excellent predictor of long-term stock market returns, while the interest rate level offers almost no additional predictive value. So while low rates explain high stock valuations, they do not justify them -- at least not for investors (like us) who are focused on long-term returns.
"Foreclosures will be limited to subprime mortgages." The word "subprime" denotes a mortgage in which the borrower had a low credit score. Many of the riskiest mortgages -- those with low teaser rates, no verification of income or assets, a very low down payment, or any combination thereof -- were granted to non-subprime borrowers with high credit scores. As more and more non-subprime loans reset in the months ahead, we will likely see an increasing rate of foreclosure among non-subprime borrowers.
"There is a bubble in hard assets." Pick a random sampling of people on the street and tell them you think it's a fantastic idea to buy gold. Most of them will laugh at you. If the day ever arrives when they all agree with you, or better yet laugh at you for telling them it's a good idea to sell gold, then you'll know we are in a bubble.
"The US current account deficit is a sign of strength." The current account deficit -- the difference between what we pay out to foreigners for goods, interest payments, etc. and what they pay to us -- is offset by the capital account surplus, which is the difference between what foreigners invest in our country and what we invest in theirs. This story maintains that the current account deficit is just a side effect of the high capital account surplus, which is itself caused by foreigners' burning desire to invest more money in the US. This might be believable if the foreign investment money was being used to invest in wealth-generating means of production, but that's not going on at all. The money is largely being used to finance government deficit spending and to enable consumers to buy more consumption goods -- including houses -- than their incomes would otherwise allow. This doesn't seem like such a great investment opportunity to us.
"The California housing market is near the bottom." We refer you to the graph above, in addition to the slew of impending risky mortgage resets, rising mortgage rates, tighter lending standards, weak sales volume, high inventory, heavy job loss in the housing-related industries, and the fact that despite the declines to date, homes remain vastly overpriced.
That's just a sampling of some of the more pervasive stories at work in the financial markets. We could go on, but we'll spare you.
It can be very lonely standing apart from a crowd that has convinced itself of a story, but in the end, logic prevails. We do mean "in the end" -- sometimes it takes an amazingly long time! Eventually, though, the truth of the matter does reveal itself.
At that point, of course, a new batch of stories takes the place of the old. We don't mind, though. As a matter of fact, we welcome the prevalence of financial market stories, because they can provide a big advantage for patient investors who are willing to diligently examine the facts, to dig deeper into what's really going on, and to invest accordingly.
