Today’s rate cut of 3/4% came sooner than expected—but is still not enough.
 
With the 2 yr note now down to 2.05%—the Fed will now need to get down to 2%–or lower.
 
The question is–how–and how soon—as well as—will they ever get ahead of the curve will all of its implications.
 
The cut today—just 8 days before the next scheduled meeting—automatically guarantees AT LEAST another 1/2 pt cut next week to 3%. With any luck, the Fed will cut 1 full pt to 2.5%—setting the stage to “catch” the market by March with an inter-meeting cut in Feb before the March  meeting. I now see the fed needing to get to 1.5% by May. No one believed me before–believe me now.
 
What is interesting about all of this is that while you see an economic capitulation due to the FED being too restrictive for too long—this downturn, started and caused by higher rates which caused the worst housing downturn since  the Great Depression—is actually starting to see the first signs of life. Let me explain–
 
While all of the pundits have been pondering whether or not the US would go into a recession–it was clear to me from the beginning that the recession started Aug 10th–just after the capital markets froze. There is little doubt that we were heading that way–but the seizing of the markets accelerated the decline. The Fed’s response to this was–and has proven to be–anemic as they stay consistently behind the curve, and noticeably above the 2 yr bond. They have continued to mis-read the unemployment levels—due to the fact that a huge amount of people have lost their jobs–but these people were not employed, they were independent contractors! They were real estate agents and brokers, mortgage brokers and bankers, appraisers and pest control companies, movers, plumbers, electricians,  carpenters, etc. You get the drift.
 
Against this backdrop of a worldwide stock market decline and clear capitulation of panic selling—–has come the first glimmers of spring with the first signs of life in the housing market—the very market that led the downturn. How do I say this?
 
We started to see the first signs of life when searches for real estate turned the corner December 26th—when all of a sudden, our budgets in certain markets were not enough to satisfy the demand for people looking for homes. We continued to see this starting Jan 3rd when real estate leads—those people who either contact us because they want more information on a home or an appointment  to see them–simply exploded. This has been starting to be reinforcing by the number of people who have not only contacted us–but want to see homes NOW. Up to this point, the attitude by prospective home buyers has been–I’d like to see the home–maybe in a week or two–”I’m kinda busy.” This has dramatically shifted.
 
As you know, housing tends to lead a market into a recession—but it is also the leading indicator for an economic revival and tends to pick up midway thru the recession. Since postwar recessions tend to last 10 months–midway would be Feb 10th—and we’re not too far from that. While it would be very easy to say that this is not a normal credit-led downturn by any means [and I completely agree] this must be held against these important facts—that the Fed started lowering rates immediately following Aug 9th’s debacle [rather than waiting for the economic fall-out to be more widespread before finally acting]—and that they actually started to reflate the economy starting last May when they embarked on a policy of increasing M 3 by a 15.3% annual rate. These two VERY important factors will get us out of this sooner than the consensus feels. Additionally, I now expect real estate prices to be HIGHER at the end of the year and a huge number of transactions to occur due to these sharply lower interest rates. I feel that today’s emergency interest rate cut not only says that they are going to be cutting much more than people expected—but it will accelerate the home buying process and recovery—since we have three years of pent-up demand to go along with these sharply lower interest rates.

While the newspapers and pundits continue to discuss and hypothesize on whether we could go in to a recession—-we not only already IN a recession, but probably mid-way through the recession. Typically, recessions are reported after they are finished and are backwards-looking. I believe that when the capital markets froze mid-August, that they economy quickly declerated into at least 2 quarters of declining growth. It’s that simple.
 
The residential real estate market’s decline will have brought about the recession, and the residential real estate market will bring us out—as it ALWAYS does. The typical post-war recession is 10 months, and if this one started on/about August 15th, then typically it would be finished June 15th. The housing market normally picks up MID-WAY thru the recession [due to lower interest rates and the affordability] and that would be expected to be Jan 15th.
 
We have some unusual things going on now that seems to be escaping the media who loves to write about”gloom and doom”—but seems reluctant to write about the news.

Simple fact—housing inventory has now declined across the United States 4 months in a row! In some areas–the decline in inventory has been 10% or more–in only the last month.

While the Federal Reserve was keeping tight on interest rates, they were quietly expanding the money supply at a great rate–and have increased the M3 by approximately 15% in the last 12 months. This is huge— will play a great role in housing’s recovery—-and will bring a general econimc recovery sooner rather than later.

Since we operate a national real estate business, I can tell you that leads for buying have exploded since the first of the year.
 
As you all know, I have been expecting the real estate market to begin its recovery in March–led by an increase in transactions. Getting leads in January should lead to transactions in March. I also expect prices on homes to begin to turn north ahead of everyone else—either in the fall of this year, or the spring of next year at the latest. With inventory declining, and transactions expected to be picking up soon, it won’t be long until the media reports the upturn, and then people will return to the real estate market in droves [3 years of pent-up demand by people waiting until it’s “safe” to buy.] Once the inventory bulge is taken out of the market, prices will start to recover.
Classic economics–classic people investor’s psychology.
 
Bernanke’s speech sets the tone for a 3/4 % rate reduction on Jan 30th to 3.5%, and clears the way for a reduction to 3% mid-March. The 2 year treasury is now near 2.5%—so expect Fed funds to get near to the 2-2.5% range, and we could be at 2.5% at the May meeting!. I don’t think they will need to go lower because the Fed increased the money supply much earlier into the slowdown than people realize—and because/since they did—the housing market will show stronger positives this spring than people expect—which will lower the need for the Fed to lower the rates, and because I expect the decline in bond yields to be over sooner than later since the bond market will begin to see this upturn before the Fed and everyone else. Over the next 6 months you will see parts of the economy declining—and the housing market start to recover.
 
Let’s look at the housing inventory decline…

The change in the number of homes for sale at the end of December compared to a month earlier–
 
Boston - 13.3%
Chicago - 8.6%
Dallas - 8.2%
Los Angeles - 8.5%
Minneapolis - 9.8%
Orange County, CA - 10.2%
San Francisco Bay -11.3%
Seattle -10.7%
San Diego - 8.8%
Washington DC area - 8.4%
etc.
 
Fact is—-when you look at the numbers, and remember that this is the 4th consecutive month of inventory decline—the numbers are startling—-especially since all we keep hearing about are foreclosures causing inventory to swell. Maybe news reporters ought to report the REAL news on this. Once they do–the recovery will be well under way!
 
The Wall Street Journal had this to say yesterday-

“market performance is ugliest before and in the early days of a recession as investors panic about the effects of a downturn on earnings. In the three recessions between 1980-1991, stocks turned positive before the recession ended, leading to runaway gains in the months after the downturn. Stocks on the whole rose modestly during those recessions”

This leading me to believe that the worst of the downturn is probably here—and we have experienced a small up-move in stocks after the recent correction although it is way too early to call an end to the decline in equities. However, due to declining rates, expectations of large decreases coming soon, and the ease that corporate earnings will be able to beat year-over-year comparisons–especially in the financial and housing sectors—this portends a strong advance in stocks.

In the last year, M3 has been growing by approximately 15%. This is a basic measure of money supply and liquidity—and this is huge. While the focus has been on the Federal Reserve and how much they will/would drop interest rates to help the real estate market and general economy—what’s been going on behind the scenes speaks volumes. They are increasing the money supply at an enormous rate to stabilize the housing market throughout the USA. It is important to note that interest rates certainly have not been high—it has been a major problem that banks have stopped lending, tightening terms, etc.

I suspect mortgages will be in the 5-5.5% range in the spring—and this–along with the lower prices—should finally put the floor under prices. As this occurs–the risk premium will dissipate, interest rates on mortgages will become cheaper—and housing will begin its normal recovery. There is no question that the Fed is doing everything they can to stabilize the housing markets—and once they turn up ever so slightly—you can expect lower rates as the risk premiums dissipate.

While housing fundamentals are certainly improving—they will continue to do so against the backdrop of continued price declines. This is simply the opposite part of the cycle—remember when housing prices soared even though rates were going higher and inventory was growing? at THAT time—prices increased DESPITE declining fundamentals.

Inventory has been declining now for 3 months—and this is extremely important. This, along with lower interest rates, are the fundamentals that will eventually bring the supply and demand into balance. At some point—due to a drastic reduction in new homes started over the past 2 years—will result in higher prices for real estate as inventory will continue to shrink and shrink—-and let’s not forget—we basically have 3 years of pent-up demand by home buyers.

Combining all of this with expected government action to hold off foreclosures, could bring the real estate market back a lot sooner than most expect.

It is becoming apparent that the Fed will lower 1/2% on Tuesday. There would have been no other reason for the Kohn and Bernanke speeches last week.

The 2 yr note is down to 2.97—-while the 10 yr bond has risen in yield to 3.99% from 3.85%. I think it is safe to say that the speeches were done to stop the stock market slide–and to give the market the assurance it needed about the cuts. I believe that the rise in the 10 yr bond is EXACTLY because the bond market is saying that the Fed is finally starting to catch up to the declining economic fundamentals—

Assuming the Fed does lower to 4%–and the 10 yr bond stays where it is—then it will be the 1st time in a very long time that the fed funds were NOT above the 10 yr bond—and this usually signals the end to any market decline. I have very little doubt that the fed will need to continue to lower—i think right now the only debate is whether they go to 3.5 or 3.75% on Jan 30th—and we’ll need to see the data. As I have said all along—I expect fed funds to be nearer to 3% when the cycle is finished.

The housing party was a big one. everyone got drunk. the vomiting is almost over—but the headaches and malaise will linger and linger. I suspect that mortgages will no longer trade just 1.25% above the 10 yr bond in normal circumstances—not when the Fed is prepared to renegotiate the mortgages. no one would take the risk without more premium. This will probably lead to lower rates than people expect—and that these lower rates could stay with us a lot longer than people expect.

We have just experienced back-to back declines in monthly inventory for housing. As I spoke about before—the fundamentals for housing are now starting to improve dramatically. Inventory drop not too big—but interest rates are coming down a lot—and will come down more—not only because the fed is lowering rates—but because the spread between the 30 yr fixed mortgage and the 10 yr bond will continue to shrink after getting to be about 2-2.5% above the 10 yr bond—instead of the normal 1.25%

i suspect mortgages will be in the 5-5.5% range in the spring—and this–along with the lower prices—should finally put the floor under prices. as this occurs–the risk premium will dissipate—-and housing will begin its normal recovery [do NOT–for a second–think “this time it’s different”—-those are famous last words!].

While housing fundamentals are certainly improving—-they will continue to do so against the backdrop of continued price declines. This is simply the opposite part of the cycle—remember when housing prices soared even though rates were going higher and inventory was growing? at THAT time—prices increased DESPITE declining fundamentals.

Evaluating the stock market now—i think the market has priced in a fed cut of 3/8ths—-and by that I mean that if the fed lowers only 1/4% [doubtful] expect a pretty good sell-off. if they lower 1/2%—expect a nice rally. 

Expect a strong stock market throughout 08. it may be starting now—but i suspect that it might take until February. Expect the hardest hit–but QUALITY financials to recover and lead the market higher. everything the fed is doing is about finacials. Please note that the yield curve has risen to 40% [2yr-10yr bonds]—and that the DIRECTION [widening] and the % amt—are bullish. bullish. bullish. That said—we face the last amount of turbulence until everyone buys in to this.

With the Federal Reserve meeting again this week, it is now time to update our market expectations.
 
As many of you know, I have been expecting a major move down in interest rates, caused by the biggest housing decline since the Great Depression. While many pundits on television have been talking about the problems in the housing market being “contained”, I have maintained that this is simply impossible—-and with price declines of 5-45% depending upon the region—not only are we seeing economic weakness, it would be hard to argue that places like Florida are not in a pretty deep recession.
 
The problems created by having mortgage money too easy at the end of the last cycle—with “no down” no doc” “no credit” etc loans fueling the last run-up in prices have certainly come back to bite everyone with foreclosures rapidly rising throughout the USA, and with price declines across America. These declines [ignore what the media reports] have been anywhere from 5-10% in the “strongest” markets like Los Angeles coastal areas to as much as 45% in many areas of Florida. Las Vegas, Inland California, and Phoenix are also amongst the hardest hit.
 
Declines in prices have varied based on the amount of new home building in any particular area, as wherever there is a large inventory of tract housing or condominiums there has been the greatest decline in price. Much of this has to do with speculators who created an artificial housing “shortage” by buying 5-10 homes a piece with the idea of simply flipping them at higher prices to the next person to come along. As soon as mortgages got tighter, and the inventory of new homes started to manifest itself—the “music stopped” and inventory grew rapidly.
 
There is no question in my mind that Fed Chairman Bernanke is completely aware of the problem, and has come to grips with the fact that unless this is headed off quickly, we may not only be using the “R” word for Recession—but would have to think about the “D” word–for Depression. It must be kept in mind that the last time we had a housing decline like this WAS around the time of the Great Depression of 1929-1933. This HAS to be the reason behind the 1/2% cut in rates at the last meeting
 
I do NOT say these things to scare you–because I think the worst of the housing market decline is behind us—and I expect the market to start its recovery early next year.

I expect the Fed to lower interest rates on Wednesday—and the only issue is whether it will be by 1/4 or 1/2%. Hopefully, it will be by another 1/2%.

I also expect them to lower rates Dec 11th, the end of Jan and March—-bringing Fed funds down to the 3-3.5% range from the 5.25% it was until this past summer.
 
The Fed will be putting the “pedal to the medal”—NOT to bring prices of homes back to their July 2007 peaks—but in order to create a “bid” under the market.

They simply MUST create an environment whereby people can see that houses will resume their normal appreciation levels alongside inflation. At the moment, we sit with 3 years of buyers sitting on the sidelines waiting for the market to stabilize before THEY buy. Once the PERCEPTION of housing weakness passes, expect the market to regain its health—fed by these interest rate declines.
 
Along with the decline in interest rates—and along with the stabilization of the housing market—will come the elimination of the “risk premium”. Historically, 30 year fixed mortgages have tended to be whatever the 10 yr bond was paying [now at 4.40%] plus 1.25%. That would translate to a fixed rate of 5 5/8% and the jumbo at 6%.

However–because of the perceived risk—banks are charging about 1/2% more—which may not sound like much–but it is making mortgage payments 10% higher than they would be—and this has a bad influence the housing prices and the market itself.
 
I’m expecting the 30 yr mortgage to get back down into the 5.25-5.5% area—with the jumbo about 1/2 point higher.
 
The continuing of interest rate reductions have helped to keep the stock market at or near record levels—and I expect the stock market to rally strongly at least until the Presidential election. Since this tends to happen every 4 years anyway–I’m hardly going out on a limb here. This stock market advance will help to bring the more affluent home buyer back into the market along with lower interest rates. This housing recovery will be led by the HIGH-end buyer—-and this is normal, with the last cycle being led by the 1st time home-buyer being the anomoly.
 
The Fed lowering rates will also make mortgages a lot cheaper for anyone willing to get an adjustable rate mortgage and will help to bail out those people who bought homes with adjustable rate mortgages that are–or are about to–reset at much higher rates which could lead to more defaults. I have little doubt that the Fed will be moving quickly to help this group along.
 
While much will be said over the next couple of years about the Fed bailing out the speculators—this will NOT be the case. Those investors/speculators who bought homes at $700k in inflated markets–only to see prices drop to $475k—will be forced under—-but the housing market WILL start its recovery from this $475k level gradually as people realize that prices have gotten back to $500k—and that prices are heading higher. Since full price recovery might take years—the speculators will be in deep trouble, and not bailed out. For the individual homeowner who stays in their home—eventually they will get their money back.
 
The Fed also remembers what happened after the Tax Reform of 1986 which caused real estate to decline—the banks ended up with the real estate–and then YOU and ME had to bail out the Savings and Loans through our tax dollars.

The Fed will be moving quickly here to try to have that not happen—as we have seen disturbing news from companies like Merrill Lynch, Countrywide, Citibank, Washington Mutual etc—the high quality institutions—while we have also seen scores of mortgage companies fail and file chapter 11.
 
I think they will be successful—-and I feel that housing prices will begin its recovery in late 2008—after the actual sales recovery starts this spring when new home builders will be ending their price slashing to clear out unsold inventory. Once we start to see noticeable reductions in homes for sale, we know that we will resume a more normal real estate market with normal levels of appreciation.
 
One thing needs to be kept in mind—-we had a real estate market that was “overvalued”.

After the decline—it is more normal to swing to “undervalued” and then begin a recovery. It is rare for a market to go from “overvalued” to “fairly valued”—so there is probably some catch-up appreciation to be had in this recovery as we eventually get back to a normal market.
 
Those people buying homes this spring should be handsomely rewarded over the years to come.