What’s Holding Me Back from Turning Positive on the Housing Market

Bear Market RallyHouse prices have gone up! Does this mean a recovery in the housing market is in? Don’t jump in quite yet, dear reader.

The collapse of the housing market that started in 2006 has taken its toll on the U.S economy. Nationally, U.S. home prices are still down 31% from where they were in 2006. Home prices will need to go up almost 45% for home prices to get back to where they were six years ago.

Private equity firms are on a spree of buying foreclosure homes. A company backed by The Blackstone Group L.P. (NYSE/BX), Colony Capital LLC, owns about 3,600 homes facing foreclosure. (Source: Wall Street Journal, September 11, 2012.).

Blackstone and other private equity firms such as Och-Ziff Capital Management and Oaktree Capital Group LLC have raised more than $8.0 billion to buy houses negatively affected by the housing market crash.

These private equity firms are buying foreclosure homes, because they can easily rent them—notice I didn’t say sell them—and earn higher return compared to other investments.

For a healthy housing market recovery, there must be individuals buying houses and living in them, not investors buying to rent properties out. Money at private equity firms flows to places where it gets the highest return. Buying cheap, foreclosed homes and renting them at a return higher than the cost to buy home makes big sense for private equity firms.

The effects of the home buying spree: demand by investors for foreclosure homes in Phoenix and Los Angeles has driven up the prices of homes to a point where it is not feasible for private equity firms to buy and rent anymore. ( Source: Bloomberg, August 30, 2012.)

Why the higher prices? The lenders normally would sell foreclosure homes in bulk, but they are now selling them one at a time. This way, lenders can get a better deal on house prices.

A surprising statistic has the vast majority of borrowers with negative equity still paying their mortgage payment—that’s 84.9%. (Source: Los Angeles Times, September 12, 2012.) The housing market has a long way to go before this imbalance is corrected.

Why are private equity firms and not individuals taking part in the housing market? Because buying foreclosure homes usually requires cash. To own a house, an individual needs a good credit score, a good job, and a good down payment—three things millions of Americans do not have.

But here is my real problem with the housing market…

Inflation is spiking. I write regularly in Profit Confidential about how rising inflation, the unprecedented rise in government debt, and the money supply will eventually push interest rates much higher than they are today. What happens in three years’ time if the standard U.S. 30-year mortgage (currently at an interest rate of 3.57%) jumps two percentage points to 5.57%? The housing market will get hammered again. As I believe interest rates will rise in the next three to five years (could be sooner than that), I can’t turn bullish on the housing market. (Also see: “The Great Housing Recovery Hoax.”)

Michael’s Personal Notes:

Well, it finally happened. As predicted and much expected, the Federal Reserve announced QE3 yesterday afternoon. And what a “QE3” it was! The Fed will buy $40.0 billion a month in mortgage-backed securities. If it’s 10 months of buying, add $400 billion in newly created money. If it’s 25 months of buying, add $1.0 trillion to the Fed’s balance sheet.

I have been writing that the market would give us another big blow on the upside when QE3 was announced, and that’s exactly what we got yesterday with the Dow Jones Industrial Average up 206 points to a new high for the year!

What happens now?

The stock market rises a little more as analysts figure out the big banks can unload more of their junk securities and improve their earnings (albeit without more retail lending, which is what the economy really needs).

The market then goes down as American consumers, who make up 70% of the nation’s GDP, but who get next to nothing out of QE3, close their wallets even further, hurting the earnings of non-financial listed companies.

Where the Market Stands; Where it’s Headed:

We are near the end of a bear market rally in stocks that started in March of 2009.

What He Said:

“In 2008, I believe investors will fare better invested in T-Bills as opposed to the stock market. I’m bearish on the general stock market for three main reasons: Borrowing money in 2008 will be more difficult for consumers. Consumer spending in the U.S. is drying up, which will push down corporate profits.” Michael Lombardi in Profit Confidential, January 10, 2008. The year 2008 ended up being one of the worst years for the stock market since the 1930s.