<September 28, 2022>
In the Seinfeld episode “The Wizard”, George Costanza speaks with his deceased fiancé’s parents, the Rosses. Mrs. Ross invites George to an event supporting the Susan Ross Foundation. Not wanting to go, George says he can’t attend since he’s going to his house in the Hamptons. Of course, George doesn’t have a house in the Hamptons.
Unbeknownst to George, his friend Elaine also speaks with the Rosses in a separate conversation. George and Elaine talk shortly after their encounters.
George: So, I ran into the Rosses again.
Elaine: Oh, right, at the coffee shop. Where did they get the idea that you have a place in the Hamptons?
George: From me.
Elaine: What did you say?
George: I told them I have a place in the Hamptons. What did you say?
Elaine: I told them you didn't. And I laughed and I laughed.
George: So they know. Those liars.
Elaine: But you lied first.
George: But they let me go on and on. They never said a thing. You don't let somebody lie when you know. You call them a liar.
Elaine: Like you're a liar.
George: Yes! Thank you! Was that so hard?
To force the Rosses into acknowledging he was lying, George invites them to his Hamptons house. Surprisingly, the Rosses accept his invitation. As they get into the car to drive to his imaginary house, George gives the Rosses one last chance.
George: So here I am. Ready to take you to the Hamptons.
Mrs. Ross: Sounds grand.
George: Do you have your bathing suits?
Mr. Ross: It's March.
George: Speak now or we are headed to the Hamptons. It's a two-hour drive. Once you get in that car, we are going all the way to the Hamptons.
As the Rosses get into the car, George says to himself, “All right, you want to get nuts, let’s get nuts!”
During their drive, George goes over some of the details of his house, explaining it has two solariums and even two horses—Snoopy and Prickly Pete. The Rosses play along and ask George to pull over so they can buy a housewarming gift.
Chairman Powell and investors are currently on a similar ride to a nonexistent destination. Chairman Powell has turned hawkish, professing that higher rates and QT are possible after years of substantial debt growth and unprecedented asset inflation. Conditioned by 13 years of easy money and numerous QE bailouts, investors are going along for the ride, also believing the Fed can tighten without a major market dislocation. In effect, Chairman Powell and investors seem to believe at the end of their trip (tightening cycle), Powell’s legacy and investors’ capital will arrive safely at some sort of soft landing.
In our opinion, investors believing the worst is behind them are neglecting the extraordinary heights asset prices and policy extremism reached during the current cycle. Market cycles that soar over 600% from their lows and reach valuation metrics rarely seen typically do not end with a wimpy 19% decline from all-time highs.
End of the cycle drawdowns tend to be commensurate with the excesses of the cycle, such as mortgage debt growth during the last bubble. Mortgage debt grew from $7.6 trillion in Q1 2002 to $14.7 trillion in Q1 2008. When the housing bubble popped and the last cycle ended, the S&P 500 lost approximately 50% of its value. Excesses of the current cycle—including government debt growth and Fed balance sheet expansion—have been even greater, and in our opinion, have created a similar risk of a meaningful market drawdown.
During much of the current cycle, aggressive debt growth, debt monetization, and record fiscal deficits have stimulated the economy and asset prices. It’s been an ideal environment for corporate profits and margins.
Given our belief that many of the drivers of the current profit boom are artificial and unsustainable, we’ve avoided using trailing 12-month earnings for valuation purposes. In our opinion, 2021 and the first half of 2022 were anomalies, inflated by COVID stimulus, a gargantuan increase in debt monetization (QE), unchecked pricing power, and record high asset prices.
Many of this cycle’s earnings tailwinds are in the process of being replaced with headwinds. With equity and bond prices currently down year over year, the wealth effect has turned negative. Further, without additional stimulus checks, consumers are struggling to maintain their standard of living due to declining real incomes and the accumulated loss of purchasing power. As the drivers of demand lose strength, corporate costs continue to rise with labor, inventory, equipment, and capital, all becoming more expensive. The strong dollar is also becoming destabilizing and a drag on corporate earnings.
In our opinion, the long overdue normalization of corporate profits is currently underway. As demand begins to falter and corporate costs remain elevated, we suspect a growing number of companies will announce lower earnings guidance later this year and into 2023. We anticipate businesses tied to housing will lead the way. While healthy backlogs will likely keep results respectable in the near-term, recent reports from homebuilders show a sharp decline in orders, or future activity.
Toll Brothers (TOL): “As our third quarter progressed, we saw a significant decline in demand as many prospective buyers step to the sidelines in the face of steep increases in mortgage rates, significantly higher home prices, a volatile stock market and rising inflation. As a result, our net signed contracts were down approximately 60% in units compared to last year's historically strong third quarter.”
KB Home (KBH): “Reflecting lower demand stemming from higher mortgage interest rates, inflation and various other macroeconomic and geopolitical concerns, net orders of 2,040 and net order value of $979.0 million decreased 50% and 51%, respectively.”
In addition to analyzing publicly traded companies tied to housing, we also monitor the local market, as Florida often leads national housing trends. Given how much of our local economy is tied to housing, it’s easy to find trusted sources on what’s happening on the frontlines.
My favorite mortgage broker and realtor expert recently informed me business has stalled. He said many sellers are in denial as they refuse to acknowledge the environment has changed and continue to price their homes as if it were 2021. Meanwhile, buyers are struggling with higher rates and the feeling of being trapped by their current low-rate mortgage, along with relatively affordable property taxes. My contact also said refinancings have gone to zero. And finally, he said homebuilders are once again reaching out to realtors and increasing commissions. During the boom, he noted commissions fell to 1% as homebuilders didn’t feel the need to use realtors. Currently, commissions have increased to 3% (in addition to bonuses) as builders need help finding buyers. He noted that the commissions builders pay agents have historically been a very good indicator of housing demand.
Another local housing expert I recently spoke with works for a leading door and window distributor. She confirmed the slowdown, informing me new orders have practically stopped after being extremely robust a year ago. She said, “We went from being unable to keep up with demand to getting 70% fewer orders almost immediately.” Her recommendation was to not buy a house. “When orders get this bad, things are about to crash!”
With the housing market transiting abruptly from red-hot to frozen, we believe many businesses, investors, and policymakers will be caught off guard by how quickly economic trends shift. Once the new reality sets in and prices adjust, we expect the sudden slowdown in housing to place further pressure on consumer spending and corporate earnings.
George and the Rosses eventually make it to the end of Long Island. As they knew all along, there wasn’t a Hampton’s house.
Mr. Ross: This is the end of Long Island. Where's your house?
George: We go on foot from here.
Mr. Ross: All right.
George: There's no house! It's a lie! There's no solarium. There's no Prickly Pete.
Mr. Ross: We know.
George: Then why? Why did you make me drive all the way out here? Why didn't you say something? Why? Why? Why?
Mrs. Ross: We don't like you, George.
At the end of the current market cycle, we suspect investors won’t be too fond of the Federal Reserve either. While the Fed has given investors what they’ve wanted for many years, we believe we are entering a period where the consequences of the Fed’s policy of unlimited money creation are finally coming home to roost. Instead of arriving at a soft landing, we see an earnings recession and significant downside risk to home and equity prices.
We never believed the Fed could get out of the box it placed itself in after years of overly aggressive and intrusive monetary policy. Ultimately, we expect Chairman Powell will be forced to admit he doesn’t have a house in the Hamptons and will once again pull out the Fed’s worn-out playbook and abruptly shift policy. In effect, the Fed will have to admit that a hawkish monetary stance is incompatible with current debt levels and an economy overly dependent on asset inflation. At that time, we expect a growing number of investors will discover what we’ve longed believed—the Fed is trapped. And if the Fed wants to get nuts by continuing to tighten, let's get nuts! We're prepared for it.
Eric Cinnamond
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Definitions:
S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
Whilshire 5000: Wilshire 5000 Index is a broad-based market capitalization-weighted index that seeks to capture 100% of the United States investible market.
Quantitative tightening (QT): QT refers to monetary policies that contract, or reduce, the Federal Reserve System (Fed) balance sheet.
Quantitative easing (QE): QTE refers to monetary policies that expand, or increase, the Federal Reserve System (Fed) balance sheet.
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