In the late 1990s, as the stock market boom turned into a bubble and drifted into the stratosphere, investment books began to appear with titles that sounded like an auction sale gone berserk. Dow 30,000 by 2008, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market, The Dow 40,000 Portfolio and, finally, the pinnacle of the genre, Dow 100,000: Fact or Fiction.
You can still buy them on Amazon.com. What I couldn’t find was any reference to a wry comment I heard when the Dow first hit 10,000 in 1999, warning that those neat milestones ending in zeros may occasion a burst of optimism when they are reached, but that they have traditionally proven extremely sticky. It took the Dow 18 years before it could break above 100 in 1924. The index also spent a decade and a half marking time around the 1,000 level before 1985. Of the seven years since the Dow hit five digits, it spent a total of three years below 10,000.
So, it may be presumptuous as well as premature to predict an imminent quantitative leap for the Dow, especially since even at current price levels stock market valuations, such as price-to-earnings ratios, remain elevated by historical standards.
Still, even though the Dow may not triple in value imminently, a strong rise for U.S. stocks is likely. Ironically, the main reason for our current optimism derives from what many analysts believe is the No. 1 risk for the U.S. economy — the possible bust in the overbought residential property market.
New Investment Craze
In 2001, when the Internet bubble burst and the Nasdaq market tanked, stock investors sold off good shares along with the bad. As is often the case, unsophisticated retail investors were burned the worst — they waited until the last moment to pile into the stock market and bought high just before the market started to head low. Not only were they burned by the pricking of the bubble, but the reputation of stock investing was additionally undermined by a rash of corporate governance scandals, insider trading and suspicions that investment banks’ analytics were subservient to the underwriting business.
Although the U.S. economy began to recover in 2003, and stock prices began to rebound, many retail investors didn’t return to Wall Street. And why should they have? They now had an appealing alternative — a booming residential real estate market.
The U.S. real estate market is a $10 trillion operation. The dollar value of single family homes measured 16 percent of GDP last year, or around $2 trillion. Of this, 20 percent was purchased for investment purposes. True, real estate, unlike shares in personal investment portfolios, is typically bought on margin, with only about 15 percent to 25 percent down payment. Still, this meant that as much as $100 billion in cash went into the real estate market
This is only the tip of the iceberg. Home prices more than doubled during 2000-2005 in many parts of the country. To many households, this provided an illusion of wealth. They no longer needed to save up to buy a car or plan for retirement, because they knew they could cash out of some equity in their homes. Eventually, they would be able to sell their dramatically appreciated homes and retire comfortably to Florida. Refinancings were running at an annualized rate of $558 billion in the first quarter of this year, and analysts believe that homeowners were using 50 cents of each dollar taken out of home equity to fund consumption.
The real estate boom doubtless contributed to the rally in the stock market since 2003. Real estate investment trusts (REITs) far outstripped broader market indices in the first half of the decade. There are 11 REITs in the S&P 500 index, contributing to its gains. Home builders also appreciated strongly, before losing ground this year. The shares of Toll Brothers (TOL), a luxury homebuilder based in Horsham, Pa., have been halved from their peak in mid-2005, but they are still up nearly 250 percent over the past five years.
Needless to say, a hard landing in the real estate market would be extremely damaging for the U.S. economy. Investment in residential construction accounts for over 6 percent of GDP, the highest proportion in half a century, and 1.5 percentage points higher than the long-term average.
And then there is the ripple effect on various goods and services that are related to the real estate market, from furniture and appliance makers to lawyers and movers. The country now has over a million licensed realtors, one for every 200 working adults.
The banking sector also feels the iron grip of the residential property sector. Real estate loans, including mortgages, home-equity loans and commercial property loans, now account for just over one-third of the U.S. banking industry’s $9.3 trillion in assets. If their holdings of mortgage-backed securities and other real-estate-related assets are included, the proportion rises to 43 percent. Banks rely on real-estate-related lending and fees for some 60 percent of their profits.
Economists warn that a real estate boom of such proportions — with its massive rise in home prices, the addition of new housing stock and creative lending schemes — has never been seen before. Still, while the risk of massive defaults, repossessions and price declines has increased, an overall collapse in the market is unlikely, for several reasons.
1. Most Americans reside in their homes. Even if home prices drop, they will be extremely reluctant to walk away from their homes and leave their families homeless.
2. Despite two years of tightening by the U.S. Fed, interest rates remain low. The yield on the 10-year Treasury, used to set mortgage rates, is below its levels in mid-2004, when the Fed began raising its rates.
3. Credit conditions remain easy. Creative lending practices, such as sub-prime mortgages and option ARMs, enable lower-income and underemployed homeowners to keep making their monthly payments.
4. Rather than taking a loss on the house, many homeowners may prefer to rent it. Rental income could help them weather a period of lower home prices.
5. The labor market remains tight. A widespread loss of income is unlikely in most parts of the country, except places such as Michigan where high-paying jobs are disappearing.
6. Other countries, such as Australia and the U.K., which also experienced a housing bubble and then a period of high interest rates, felt a few bumps in their residential property markets, but no across-the-board price declines.
7. Finally, even after going through a refinancing spree, Citigroup estimates that the average equity in the family home still measures around 56 percent, providing a sizeable cushion for impending price declines.
However, the Office of Federal Housing Enterprise Oversight’s home price index, the definitive gauge of U.S. home prices, has never posted an annual decline since data started to be collected in 1975. Some regions may suffer more than others — and some regions, such as Northern Virginia and Florida already have. But the nation as a whole is likely to experience a soft landing in housing.
This should provide a long-awaited boost for U.S. stocks. The Dow has recently reached its highest level since late 2000, and its rise from the 2002 trough measures at around 50 percent. However, U.S. stocks have been performing poorly compared to other global bourses. The dollar-denominated Morgan Stanley index tracking stock markets in Europe, Australasia and the Far East (EAFE), has doubled in value since 2003. The Dow, meanwhile, has risen by a third over the same time period, with the bulk of the increase coming in 2003.
The Dow has substantial room to move higher once investors lose their focus on real estate and discover the potential of the broader U.S. economy. Since the start of 1990, the Nasdaq Composite index has appreciated by about 400 percent. The Dow, meanwhile, has gained only 300 percent. This suggests that to keep on a long-term pace with Nasdaq, the blue chip gauge needs to gain about one-third of its value, which would put it at around 15,000.
Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him firstname.lastname@example.org