3rd Quarter 2005: Mid-year Review

Third Quarter 2005
Market Commentary

Mid-year Review

In this report, we would like to comment on the current state of the economy, rising residential real estate prices, and the Feds response to both of these trends. We will begin with the economy.

The past three months (April - June) witnessed a number of economic indicators, which while rising, were doing so at a slower rate than a year ago; and also at a slower rate sequentially than in the first quarter. Many analysts have responded to this by lowering their sights, and downgrading equity targets. As a consequence of this, the stock market, as of June 30, was back to where it was at the end of 2004, and at a level it first crossed in early 1999, six years ago. As of June 30, the Dow Jones Industrial Index was down 4.5% for 05', and the S&P 500 Index was down 1.7%.

The good news, however, is that July has started out with a bang - with the Dow, S&P and NASDAQ all retracing within the last three weeks the losses from the first six months. The reason for this is earnings. With 40% of the S&P 500 having reported through 7/22/05, second-quarter earnings are on pace to rise more than 10% vs. a year earlier, according to Thomson Financial /First Call. Further, of those reporting, 72% have beat forecasts. These are impressive numbers in any environment; but they are particularly good given the fact that the 10% growth estimate comes on top of 25% gains in the second quarter a year ago.

This is like asking whether the glass is half-full, or half-empty. Many on the street look at decelerating growth and conclude the glass is half-empty; and that the slowing from last year's pace is in response to Federal Reserve hikes in U.S. interest rates.

We view it differently. We think the glass is half-full and improving. Why do we say this?

1) The economy is growing, and corporations are strong. Due to the five-year low interest rate period, which we may be now exiting, corporations across the board took advantage of that window to strengthen their balance sheets, and have large cash positions. Further, they are utilizing their cash by raising dividends and buying back stock.

2) The budget deficit, for this year, originally forecast at $475 billion, now is projected to come in at approximately $330 billion, reflecting higher tax revenues than anticipated.

3) Unemployment is at 5%, indicating that this three week price reversal in the market may also reflect the fact that jobless benefit claims dropped last week by the greatest amount in more than two years. Also, the New York-based Conference Board said that its Composite Index of Leading Economic Indicators increased 0.9% in June after showing little or no change in the prior two months. This June increase was the largest increase in 1½ years. It looks now as though we will have a second half pickup - building upon a 3.5% gain in GDP in the first quarter, that will probably be flat for the second quarter (due to April and May numbers), but rebound for the balance of the year.
4) Since the markets are still essentially flat for the year - we think the markets may catch up with the economy during the second half - similar to what happened last year.

Is There A Real Estate Bubble?

We are not in the business of advising anybody on real estate values. Real estate is a highly specialized, multi-faceted and localized market place, where one will do best by aligning oneself with a good real estate broker who knows a specific area and subset of that market. What we do feel compelled to comment upon, however, is not whether real estate prices have reached bubble proportions, but rather what we see as several macro-economic trends which could affect not only real estate, but the entire economy.

Further, our comments below are focused on the residential market, which we see as an entirely different market verses commercial and industrial property.

Residential real estate has been on a roll for the last five years, bringing with it an increased sense of confidence on the part of homeowners, who in turn have helped keep consumer spending at a relatively high level. We say this because there has been a sharp increase in mortgages on existing homes, unrelated to new home purchases, along with rising equity values. A good part of this borrowing has undoubtedly been used for home improvement. Nonetheless, this suggests to us that an increasing mix of the population appear to have borrowed against the higher equity in their home in order to maintain a high standard of living. Further, since the value of one's home is generally considered to be the largest asset for the average American family, and since consumption is 2/3 of the economy, it can be said that the rise of real estate prices has become a primary driver of the increase in consumption expenditures and indeed, of our economic well-being.

As recently as 10-20 years ago, and in a different environment, the following traditional sequence occurred:

a) We all bought our homes with a significant down payment (at least 20% and usually quite a bit more.)
b) The banks that made the loan would then retain the loan on their books as an asset of the bank, and
c) The Banks would then conduct a credit check in order to qualify an applicant for the loan.

In other words, the bank took a risk in making the loan, and held a mortgage on the house as collateral. If the real estate went south, the bank was left holding the bag, and would often go through a painful restructuring to stay solvent. (Anyone remember Lincoln Savings, or The Resolution Trust Company?) The banks made mistakes, to be sure, but they went to great lengths to be careful in the loans they made.

Fast forward to today's world. According to the Mortgage Bankers Association, at the end of last year close to 50% of recent home loans (in value terms) were at adjustable rates, up from 20-30% between 2000 and 2002. In California, they estimate this has been closer to 60%. Worse yet, according to Fortune Magazine, 31% of all mortgage loans made in the United States last year were interest only loans. In California, the percentages were significantly higher.

The reason this is happening is because banks aren't holding many mortgages these days, and therefore the banks appear to take little or no risk in (residential) lending. Their business model seems to be one of charging points and fees on the front end, and then securitizing the loan, and selling it to Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corp); both government agencies that together hold over half the (residential) mortgages in the country.

Our concerns are as follows:

1) The actions of the banks making these loans, and the relative ease in obtaining jumbo loans, introduces a strand of speculation and volatility into what has historically been a long term investment market.

2) The fact that banks blow out these mortgages as soon as they're made, creates a situation wherein the lender avoids the risk that exists with other loans.

3) The fact that over 50% of residential mortgages are held by two quasi - government agencies, both of which have derivative problems; both of which have had to restate earnings; and both of which have been under scrutiny by the SEC, becomes problematic.

4) Coincident with the rise in real estate values across the country is the increase in second mortgages by homeowners for purposes other than home improvements. Again, our sense is that a lot of people are using the equity in their homes to finance a standard of living that their incomes alone might not support. Moreover, to the degree that a meaningful percentage of current homeowners are financing their homes using adjustable rate mortgages, rising rates will force more people to devote more of their disposable income to finance debt and away from consumption. Thus our fear is that if rates rise too far, consumption will fall, and economic activity will suffer.

On a macro-basis, complete the circle with an observation that many of the folks described above are keeping their expenses low by shopping at a nearby Wal-Mart where literally thousands of products are brought to you at discount prices straight from China and other developing nations.

This in turn, leads us to conclude that there is a direct relationship between the rise of home equity loans in America in the hundreds of billions, and the increase in Chinese and other Far East countries in their holdings of hundreds of billions of U.S. Treasuries. On a macro-basis, our liability becomes their asset. Since this liability is secured by real estate, it causes us to think that there are a number of people who literally own their homes on margin.

Walking a tight rope

Meanwhile, Fed Chairman Alan Greenspan is busy at work, having just completed his ninth consecutive interest rate hike, which now stands at 3¼ % (overnight Federal Funds Rate). This, of course, pushes up other rates as well, with the discount rate now at 4¼%, and the prime rate at 6¼ %.

We are of the opinion that raising short terms, while it might be helpful in restraining price movements in specific asset classes, nevertheless slows down economic growth in general as well. Money is a common denominator of all business, and making it more expensive can compound the problem of dealing with our twin deficits, of which we have written in previous commentaries.

Nobody ever asks what the motivation is behind these interest rate hikes. The only response Greenspan has given which relates to this question is that "inflationary pressures are building." It's true that the high price of oil is creating inflationary pressures, but raising interest rates may not do much to stop the rise in the price of oil and gasoline: it only aggravates the situation.

So, our take is that perhaps what Greenspan is seeing, and trying to address in his own way, are the rising prices of real estate, and the impact that might be having on inflation and the economy.

Supporting that view, and our concerns listed above, is an article in the Financial Times, wherein they state that Americans withdrew $223 billion last year from their home equity. The article continues with a reference to Alan Greenspan acknowledging these figures, and who, in a recent speech, stated that "approximately half of this money shows up in increased spending by consumers."

If so, the (Financial Times) then concluded that about 40% of the 2004 increase in consumption came from home equity withdrawals. Given these facts, we believe there might be more than just a passing interest between the Real Estate market and the policies of The Federal Reserve.

In conclusion, we feel that the economy is improving, and that the stock market could rally in the second half of the year (similar to what happened last year) as investors digest an improved economic outlook. However, we feel that Alan Greenspan and the Fed will have to walk a tight rope in order to contain inflationary pressures from building in the economy while preventing too much steam from being let out of the real estate market, which has been a primary driver behind consumer spending for the last several years.

As always, we wish you the best for a relaxing summer. Thank you for your support.

Bill Schnieders

Jim Schnieders, CFA

*Please call the office at 626-584-6168 for a copy of the graph

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