Housing Bust

Housing Bust: Betting on the "Almost Inevitable"
by Steve Sjuggerud
The Rude Awakening
Wall Street, New York
Thursday, October 20, 2005

Steve Sjuggerud explains Bill Gross' theory on why a Housing Bust is coming.

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[Joel's Jotting: Just a quick one here before we get stuck
into Eric's reminiscence from his recent stay in France and
a guest essay by Rude favorite, and investment
extraordinaire, Steve Sjuggerud. Today is the final day to
get in on the MarketSafe Gold Bullion CD from EverBank.
It's a conservative investment with huge potential. Have a
look here and enjoy today's issue.

MarketSafe Gold Bullion CD

Now back to your scheduled program of financial insights
you won't find in the WSJ...

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Eric Fry, still day-dreaming out his office window about
the French Riviera, reports...

I adore Cannes, both for what it is...and for what it is
not. I love it because it is French, but also because it is
not TYPICALLY French. It is a French town, of course – a
beautiful French town bordering the Mediterranean. But many
French people are not so eager to claim it as their own.

"It is too touristic," some of the French complain, which
is a polite way off saying that Americans swarm the place.

"It is a bit like Disneyland," others say. "It is not a
typical town of the Cote d'Azur." (Which is another way of
saying that Americans swarm the place.)

"The Cannoise women are a bit plastic," one local
complained. "The pretty ones come here just to find a rich
man."

"Cannes is nice for a vacation," another local remarked,
"but not to live year-round."

Your editor respects these informed opinions, but also
holds an informed opinion of his own...and he loves the
place. 20 years ago, your editor took up residence in
Cannes for one year – an experience that afforded him the
opportunity to learn a little something about Cannes
itself, and also a little something about the Cannoise
women...He would struggle to utter a disparaging word about
either one.

Today, 20 years after that delightful year, your editor
would not hesitate to live there again...amidst the
tourists and the Disney effects and the Cannoise, just like
Dr. Richebacher has been doing for many years. Richebacher,
as the editor of the inimitable newsletter that bears his
name, produces a monthly dose of sobering investment
insights.

I snapped the nearby photo from the balcony of Dr.
Richebacher's condo. Clearly, the man has done something
right. In many parts of the world, it would be possible to
enjoy an inferior view from one's balcony.

Cannes is, in fact, somewhat Disney-like, as befits a town
that hosts the prestigious Cannes Film Festival, along with
many other high-profile events and conventions throughout
the year. But Disney-like is not all bad. The town is
spotless. Furthermore, just off of the palm-tree lined
Boulevard Croisette, Cannes becomes every bit the typical
French town of the Mediterranean. One finds wonderful
boulangeries and charcuteries, excellent restaurants and an
amazing open-air market that operates six mornings a week.

And of course, Cannes boasts one of the French Riviera's
most beautiful beaches.

"I would never live anywhere else," a self-satisfied Dr.
Richebacher declared from his balcony one evening. At 87
years of age, the Doctor may be delighted to be living
anywhere at all. "Look at this view. Where else do you have
this? And you know, from here in Cannes, I am only two
hours away from many of the most amazing places in the
world – Rome, Paris, Vienna. And the thing I love about
Europe is the history. Everywhere you go, you encounter
souvenirs of Europe's rich history. You have nothing like
this in America."

I had to agree...In more recent times, of course, we
Americans have made history – some of it good, some of it
not so good. We led an historic victory in World War II,
for example, which has enabled folks like Dr. Richebacher
to gaze out over the Mediterranean from their apartments.

But today, we are creating a different sort of history: "An
economic disaster unlike anything the world has ever
known," as Dr. Richebacher describes it. The first step
toward this disaster may be a recession that will seem to
appear out of nowhere...

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Let me state categorically that [this] sequence is barely
questionable, almost inevitable, 99% unavoidable, and in
modern parlance - a "slam-dunk."

-- Bill Gross, The Bond King, October 3, 2005

A half-trillion dollars...That's what Bill Gross is
responsible for.
 
Why is he entrusted with managing a half-trillion dollars?
It's simple... Bill Gross has delivered double-digit annual
returns in bonds for over three decades. He's the best bond
manager in the world. That's why they call him The Bond
King.

What's his secret? I think his "secret" - if you can call
it that - is that he actually thinks for himself. (This is
rarer on Wall Street than you can possibly imagine.)

Because of that, I always make a point to read his monthly
Investment Outlook when it comes out. With his investment
calls, Bill Gross may not always be right on the timing.
But as his three-decade track record shows, his calls are
nearly always pretty darn good.

So when Bill Gross comes out with a call that is "almost
inevitable" and "99% unavoidable," as he did in his latest
Investment Outlook, we have to take notice. If Bill is that
confident, then we've got to think about adjusting our
portfolios for this "almost inevetible" situation... and
we've got to figure out how to best profit from it.
Bill Gross is confident that a major change in the U.S.
economy is just around the corner. What's "almost
inevitable?" According to Bill Gross, it's 1) a housing
bust followed by 2) a weakening U.S. economy. In his own
words, he says:

"Make no mistake about it, the froth in the U.S. housing
market is about to lose its effervescence; the bubble is
about to become less bubbly. If real housing prices decline
in the U.S. in 2006 or 2007, a recession is nearly
inevitable."

Housing Bust: Sequence of Events

Bill outlines the sequence he sees. And then he backs it up
with facts. It goes something like this:
 
1) FIRST, HOUSING PRICES FALL.
 
Home prices will fall because Alan Greenspan has been
raising rates, specifically to cool the housing market.
It's just now starting to work, as holders of ARMs
(adjustable-rate mortgages) have been painfully
discovering. (According to a new, exhaustive study, a very
likely outcome is a 15% fall in real home prices in the
next five years. More on this below.)

According to Bill Gross, home prices will stop their rise
when Greenspan's higher interest rates start to be a burden
on first-time home buyers. Gross then expects banks to
tighten their lending standards. At this point, speculators
will finally "sniff the beginning of the end" of the
housing boom, as Gross says, and that'll be it.

2) AFTER THE BOOM ENDS, PEOPLE WILL STOP TAKING EQUITY OUT
OF THEIR HOMES, WHICH WILL CAUSE THE ECONOMY TO HEAD TOWARD
A RECESSION.

Bill Gross calls it the "house ATM." As the values of
people's homes have risen, people have refinanced or cashed
out some of that home value in the form of home-equity
loans. They then use the cash to upgrade their existing
homes, buy cars, or even make a down payment on a second
home.

All that ends when the home-price boom ends. The "house
ATM" runs dry. And that means no more big trips to Home
Depot or Lowe's. No more new cars. And no more second home
buying. Our "paper prosperity" - the increase in our wealth
on paper - is gone. Bill Gross sums it up:

Our economy is "acutely dependent on housing continuing to
go up, [home] equity continuing to be extracted, and
consumption continuing to be motivated by what seems to be
an endless chain of paper prosperity."

According to Bill Gross, people will stop taking the equity
out of their homes "within perhaps the next three-to-six
months." Then what? The likely scenario is a 15% drop in
the real price of homes over the next five years.

How can Bill call the top with such certainty? It isn't
just a feeling... It's based on facts. One source of facts
for Bill is a new 71-page study by the Federal Reserve. The
Fed looked at real estate markets in 18 major countries
over the last 35 years. The results were amazing...
Most people believe that "you can't go wrong in real
estate." And that "real estate doesn't go down over long
periods." But based on the findings in this important
study, that's simply not true...

While real estate rises over the long run, there are
distinct periods where it falls. In short, based on the Fed
study, right now we are right at the point where home
prices should turn over and head downward again.

The Fed found that housing booms peak, on average, four-to-
six quarters after that country's Federal Reserve first
starts to raise interest rates. Here in the States, the Fed
has raised rates for five quarters now. Based on history,
we should be extremely close to the top.

Housing Bust: After the Peak

What happens after the peak in real estate prices? The Fed
then hits us with a whopper:

"Subsequently [after the peak], real house prices fall for
about five years, on average, and their previous run-up is
largely reversed.

Wow. Want another 'wow?' Across the 18 major countries...
and across the 35 years of the study... the median real
price fell over the five-year period after the peak was
about 15%.

Now that's nationwide... of course, some areas will fall
much more than others. Again, keep in mind that, on
average, the "previous run-up is largely reversed." Ouch!
(If you'd like to see the study, you can here:

www.federalreserve.gov/pubs/ifdp/2005/841/ifdp841.pdf

So where to from here? How do we make money on this almost
inevitability?

You could bet against the housing stocks... but they are
very volatile. And besides, based on their earnings, the
stocks seem very cheap to many investors. So that makes
them a little dangerous as short sale candidates.

You could bet against retailers... As once people feel
their "house ATM" has run dry, they won't be buying as much
stuff. But here again, that bet is at least partially in
the market... Wal-Mart - THE retailer - is trading at 6-
year lows.

But my vote is for the one trade that nobody else is
thinking about...selling short junk bonds.
Here's the thinking:

If the economy tips toward recession, then more people and
more companies start to default on their loans. Which loans
are most vulnerable to default? Junk loans, of course...
loans to the highest risk borrowers.

Ah ha! Here we go... the chart below tells the story:

Right now, interest rates on junk bonds are near their
lowest levels in their recorded history, at around 8%.
I find this amazing...people are willing to accept a measly
8% interest on loans from extremely risky borrowers -
borrowers who may end up defaulting on their loans.
What this tells us is that investors are not afraid of
default today. There's good reason for that. With the
exception of the blip of a recession in 2001, we've had
relatively good economic times for nearly 15 years now.
But rainy days do come. We're making a bet that the rain
will come some day. We can even see the storm clouds...
it's the Fed hiking rates to curtail the housing boom.

[Joel's Note: So which junk bonds are poised to best take
advantage of this tricky climate? It would be a little
unfair to Steve's avid fans to give the answer away. Does
seem like a compelling argument though... Find out how to
join the profiteers here:

http://www.agora-inc.com/reports/SCF/WSCFFA00

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[Joel's Last Thought: The barrage of emails from you all
regarding Eric's, now infamous, cholesterol levels were
much appreciated. 

Swamped by all this information, I decided to call over to
a good mate of mine who works for NorthStar Nutritionals.
He alerted me to a product to promote healthy cholesterol
levels. They are selling faster than a seagull onto a sick
shrimp so I thought I should let you all know now.

Check it out here:

http://www.agora-inc.com/reports/650SVC3/W650FB50

Keep those comments and suggestions for articles a-comin'
to my BRAND NEW email address at:
aussiejoel@the-rude-awakening.com

Cheers,

jOEL

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And the Markets...