Why the weak US housing market is bad news for shares

US markets have rallied recently on speculation that interest rates will rise no further. But investors should be looking at what is happening in the US property market, says Paul van Eeden.

On Wednesday the stock market in the US rallied because Ben Bernanke indicated that he might not push for higher interest rates. Two weeks ago the market rallied because of weak retail sales numbers (see What Japanese rate rises mean for the US economy.) This market is dangerous: investors are desperately searching for good news.

When weak retail sales figures and the Fed Chairman's comments that he sees the economy slowing are interpreted as good news for stocks, then you know it is time to get out of the market.

Rising interest rates make bond yields attractive, putting downward pressure on stocks. Stock prices then have to decline so that dividend yields can again become competitive against bond yields. The opposite occurs when interest rates fall: bonds become unattractive relative to stocks and stock prices rally.

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So when investors think interest rates will not rise any further they infer that stocks may become relatively more attractive and the result is a stock market rally. Those investors who are currently buying stocks believe interest rates have stopped rising and are betting that economic growth will continue.

But if interest rates are not going to rise any further because of a risk that the economy will slow down, what will happen to corporate earnings? Even though average price to earnings ratios for US equities have come down over the past five years, there is now considerable risk that earnings declines could occur going forward. Declining earnings will cause stock prices to decline as well.

You have to ask yourself whether the Fed stopped raising interest at precisely the right time to stifle inflation without hurting economic prosperity. Then ask yourself whether the decline in the housing sector will affect consumer spending - housing starts in June fell 5.3% from May and building permits, an indication of future housing starts, fell 4.3%. Building permits are down 14.9% over the past twelve months.

The US economy is driven by consumer spending financed with debt. When consumers can no longer afford their credit card payments, they apply for a new credit card. When they cannot get any more credit cards they refinance their homes. The latter only works while home prices are rising and home prices are not rising any more. That means the only people that still have equity left in their homes are the ones who did not refinance recently. Those who did refinance may soon find that their mortgages are more than their homes are worth.

During the first quarter of this year, when home refinancings were still going strong, mortgage debt grew by $250 billion. The total increase in money supply as measured by M3 (yes, you can still calculate it) was only $194 billion during the first quarter. Now if you consider that an increase in M3 mainly reflects an increase in debt, you can see how significant the real estate market is to the US economy.

According to the Bureau of Economic Analysis, 70% of the US gross domestic product comes from consumer spending. Given that more than 100% of the increase in money supply during the first quarter came from an increase in mortgage debt, I don't think I am sticking my neck out too far when I say that real estate is currently the single most important driver of consumer spending.

When mortgage debt stops rising at such a rapid pace, I expect consumer spending to slow down as well. That, in turn, will erode corporate revenues and collapse earnings. What will stock prices do?

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.