Friday, January 05, 2007
The markets appear to be facing winds from three directions: high Core CPI, weak housing, and surprising employment growth and economic strength. There is a divergence among these elements of the economy that is perplexing. Most economists believed that the weak housing market would spill over into total consumer spending and slow the whole economy. Even the Fed has said the weak housing market could take as much as a percent off of GDP. On the other hand, Core CPI is still a worrisome 2.6%, much higher than the 1.5%-2.0% range that the Fed wants, and the job market is stronger than almost anyone had forecast. This is another one of those "conundrum" things, isn't it? The only way I can properly line up all the stars to reconcile a scenario such as the one we have today is if there is a V-shaped bottom in the housing market. Construction is only about 6%-7% of GDP, so the direct effect of a weak housing market on the economy is not huge, and if housing is, indeed, turning, contractors will hang on to construction crews, mortgage bankers will keep staff, etc., etc. A recovery in housing can explain continued strong employment, retail sales, and to some extent, high core CPI. Ah, but the professor has three hands, and with his third hand, he points to the reality of anecdotal and government data that shows that housing in many parts of the country is just very weak. You remember my place in the West that was valued at $X in 2003? My neighbor, who has an identical place, now has his property on the market for $2X. There is a new development across the street that is offering brand new units at $1.9X, for the same square footage and amenities. Today I received an email from a real estate broker offering another unit of the same vintage as mine with comparable square footage and amenities for . . . you guessed it, $1.4X. This past week the stock market has been worried about an economy that might be too strong for the Fed to cut rates anytime soon, which caused stocks to sell off. I am not in that camp, and the news on the ground supports my belief that the weakness in the housing market has not shown its full impact on consumer spending and the economy. Having said that, I believe that a weak housing market will be better for stocks in the coming year than an a upturn in housing. The reason is simple. Housing is 40% of core CPI and weak housing will lower inflation almost by itself and allow the Fed to begin cutting rates. If housing has bottomed and is starting to turn, it is tough to imagine core CPI heading lower, and no turn in core CPI means no cut in interest rates. I'm certainly not trying to bash housing, but I can assure you if housing has bottomed, the world's most important economist, Ben Bernanke, is one worried fellow.