Markets: A Rising Tide?
New York: April 30, 2007
By John R. Stephenson

"The US housing market is out of balance. Substantial further adjustment to the inventory of new homes is needed."

--Wall Street Journal, April 3, 2007

The housing market and the economy may be going in the dumper, but try telling that to the stock market which seems to be hitting new highs all the time. How is it possible that the stock market could be exploding to the upside while the economy continues to struggle and the housing market looks anemic at best?

Who knows! But academic theory suggests that this dichotomy can't last forever, but, in the meantime, investors globally are cheering on the rising tide of stock markets everywhere.

The US economic data have been anything but encouraging lately with a seemingly never-ending slew of negative data points culminating in this past Friday's surprisingly low estimate of first-quarter GDP (1.3%). Calls are mounting for the Fed (US central bank) to start easing on the interest rate front in light of steadily deteriorating housing numbers. So what does the stock market do with these dismal economic barometers? Well, it goes higher. So far, the stock market has been up 19 of the last 21 trading days.

Total home sales are at their lowest level in the last four years. As well, new home sales are close to a seven-year low. Home ownership is at a three-year low in the US and including new homes under construction, there is a total of 2.5 million homes vacant (out of 77.2 million non-rental homes in the country).

Surely, housing should have some effect on the economy, if not now, then soon. For starters, a declining housing market hurts spending on home improvements, appliances and furniture as well as building materials.

Figure 1: Housing-Related Spending Tumbles - % Change Versus a Year Ago

A slowdown in housing is bad for overall employment growth. During the housing bull market, housing-related employment added 50,000 jobs a month to the economy but now, with the housing market slowing, it is a drag on overall employment growth.

The household wealth effect is under siege as house prices start to tumble. It has been estimated that for every dollar increase in the value of a home, there is an additional 9 cents of consumer spending. With house prices heading lower in much of the country, consumer spending and confidence is falling in tandem.

On the corporate earnings front, the news isn't all that great either. Once you strip out the contribution from big energy companies (big oil), corporate earnings are growing at their slowest pace since the last recession. Certainly, this is also well below the double digit pace of earnings growth to which the stock market has become accustomed. As well, with the Democrats well entrenched on Capitol Hill, taxes are likely to rise. Yet, the stock market continues its rally.

Around the globe the story is much the same — rising asset prices. In fact, this appears to be the first global asset boom we have ever witnessed. Everything seems to be in bubble territory. From Indian antiquities to modern Chinese art, the world's assets are getting more and more expensive.

So if the economy isn't the catalyst for a rising stock market, then what is? Private equity is one catalyst that has been responsible for taking large amounts of stock out of the public's hand and transferring it into private arms. According to Lombard Street Research, the net retirement of stock in nonfinancial US companies reached 5.2% of GDP in the last quarter of 2006. Most of these takeovers were done with the aid of borrowed money (85% according to some accounts).

The money supply has been on the rise globally. Not because central banks around the world are overly accommodative, but because of the immense amount of leverage being deployed in the markets. According to The Financial Times of London , the total amount of debt issued in the global capital markets last year was just under $6.4 trillion, more than eight times the amount of equity capital that was raised during the same period. This wall of money has caused asset prices around the globe to be bid up, as deep pocket funds of all stripes scower the investment landscape for anything with a yield.

Lastly, the rising asset prices in the world's stock markets create a kind of self-fulfilling momentum of their own. As more and more people throw caution to the wind and jump into the market in the hopes of earning outsized profits, another upward leg in the stock market becomes assured.

So is it really different this time? Nope. It seems to be a characteristic of all stock markets that they seem to have an uncanny ability to make fools of the greatest numbers of people possible by defying the underlying fundamentals for as long as possible. Will the markets continue with their upward march for much longer? Perhaps. But for our money, we think investors should start thinking about investments where the valuations are more in line with the underlying fundamentals.

The best opportunities continue to be in base metal producers which are facing not only strong and sustained demand globally (largely from a rapidly industrializing Asia) but also a consolidation trend. Gold producers and the energy complex still offer investors great value and an opportunity to profit from a long-dated trend.