It seems Americans have this logic backwards as we continue in our desire and quest to "show more" while we increasingly "have less." The wisdom of "spend less than you make" is as old as philosophy itself -- yet we continue to defy its logic. So, why do we do it? We spend more than we make because we are human, because we are American, and because we can!
- As humans, we are an amazingly adaptive species capable of incredible creativity, productivity, and senseless consumption all at once.
- As Americans, we are fortunate enough, for better or worse, to be given the freedom and capacity to succeed wonderfully or fail miserably.
- A prime example of this freedom and capacity as well as its potential for success and failure is highlighted in the recent housing and mortgage struggles in America...
So, just what is the deal with housing and the so-called "sub-prime" mortgage issues and what impact does it have on the economy and financial markets? First, we should briefly define the issues, then we will address the causes and potential effects and, of course, place everything into a philosophical context to leverage the negative for positive gain as investors...
When you read or hear about "the housing industry," you should think home builders, contractors, sub-contractors, construction workers and home improvement retailers, such as Lowe's and Home Depot, as well as their suppliers.
The mortgage industry is, of course, related to housing because they finance the homes that are built as well as the existing homes that are purchased. More importantly, the mortgage industry has provided the means for Americans to perpetuate their "superconsumer" appetites by tapping into home equity with "cash out" refinancing, home equity lines of credit and home equity loans. The "sub-prime" mortgage market, which offers loans to people with weak credit histories, is coming under pressure as mortgage defaults and foreclosures are on an upward trend. It's not difficult to see the "domino effect:"
- Defaults have harmed sub-prime lenders and, in some cases, forced them into bankruptcy protection;
- Foreclosures are adding more homes to the already rising inventory of homes for sale, placing more downward pressure on home prices.
- Mainstream banks and lenders are making their credit standards more strict, which removes more would-be buyers from the picture, further perpetuating the problem.
- Over the past few years, rising home values and a rising (Bull) market for stocks made Americans feel wealthy, which encouraged the American consumer to spend more (known as the "wealth effect").
The economic big picture concern is that the housing industry supports a significant piece of the U.S. economy while the home equity "money tap" is slowly being shut off in the mortgage industry:
- Since consumer spending represents two-thirds of our economy, any threat to consumer spending is a threat to the economy itself.
- A major driver of economic growth is debt, which is the same thing as money (Bull markets are significantly supported by money supply).
- New money is created by new debt. If that money tap runs dry, the party will be over...
Every economic cycle is created and destroyed by the same phenomena: The rise and fall of the previous economic cycle was created by the technology boom and the "irrational exuberance" and greed of stock investors and corporate executives. The rise (and potential fall) of the current economic cycle was created by the home wealth effect and the real estate money tap.
For a good visual perspective, check these charts from one of my favorite macro-economic Blogs, The Big Picture:
- This chart shows trends of Mortgage Equity Withdrawal (MEW), which I refer to as the "money tap," as compared to income. You can see that, as the last major economic cycle ended, the money tap was turned up as interest rates plummeted down to 50-year lows in response to the end of the last economic cycle.
- This chart shows MEW as a percentage of Gross Domestic Product (GDP), a measurement of growth in our economy. You can see that, without MEW or what I call "the money tap," GDP would be low or negative. Could this be a glimpse into the not too distant future?
Readers of my blog know that I like to use the wisdom and logic of philosophy and history to leverage that knowledge to our benefit, primarily in the area of investing: Any student of history can look at economic cycles as a guide to strategic asset allocation. In a rather simplified and brief overview, the beginning of economic cycles are typically characterized by falling interest rates and investor fear caused by the fall of the previous cycle (think of the year 2000 to 2003). The latter stages of an economic cycle are typically characterized by rising interest rates and investor euphoria, which, arguably, is occurring now. We're not quite at "irrational" yet but investors are more optimistic than is warranted (see a previous post, "The Storm of Irrational Exuberance"). In the latter stages of an economic cycle, as we are now, prudent investors will reduce exposure (but not completely abandon) the more speculative areas (small-cap stock, "hot" sectors, emerging markets, high-yield or "junk" bonds) and increase exposure to less speculative areas (large-cap stock, defensive stock, such as Health Care, and higher credit quality bonds).
Most importantly, we must be careful not to become foolish and try to "time the market" by making radical moves with our long-term investment portfolios based on short-term "media noise."
I like to tell my clients and Blog readers that "history does not repeat, but it does rhyme." Timing the market is a fools game but "time in the market," supported by smart, strategic, and sound asset allocation that is based on macro-economic trends, is the way of a "financial philosopher..."
TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston. ACI specializes in retirement, investments, and comprehensive financial planning.