US investors don't know which way is up

Time of article published Aug 23, 2003

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Two interesting pieces of economic news emanated from the United States this week: the number of residential construction projects hit a 17-year high in July, and consumer confidence dropped in the same month.

Against the backdrop of persistent bear equity markets and much political and economic uncertainty, the reasons for the massive upswing in residential building projects is not immediately clear.

Could it be that the American consumer has suddenly been hit by a wave of "conservative irrational exuberance". Of course, investing in property has always been viewed as a defensive and conservative strategy.

But investors are often of the erroneous view that property values remain fairly stable or increase steadily year on year. This view is enforced by the fact that, by its very nature, property tends to be a long-term investment. Homeowners don't value their properties every year or "mark to market", as it were. ("Mark to market" means to record the price or value of a security, portfolio or account on a daily basis, to calculate profits and losses.)

If, for the sake of argument, investors were to buy their residences one year at a time, they would be in for a big surprise when they saw how the value of their properties fluctuated from one year to the next. Property values in a particular area depend on such factors as interest rates, immigration, politics and crime levels - all of which can cause big changes in values over the short term.

So why are residential building projects at a 17-year high? The major reason must be that, until the last two months, interest rates were at 41-year lows while rentals have been holding up well. With the cost of financing at such low levels, the yield on housing must be looking very attractive to investors. This imbalance - if there is one - is already correcting itself, due to a large increase in the housing supply. This, together with interest rates now moving upwards, is creating a dangerous situation for speculators taking a punt in the property market.

However, I have a nagging suspicion that these are not professional speculators (there aren't that many professional speculators left), but rather ordinary "John Doe" type of investors. This is rather sad, because their reasons for investing in property are wrong in at least two respects: the assumptions that interest rates will stay low and that property prices remain stable.

And what about the fall in consumer confidence? Surely there is something fishy in the state of Denmark when residential construction is at a 17-year high against a veil of falling consumer confidence. This seems to be a major contradiction. Surely, some of this must be explained by the delay between an economic condition and its effects being felt. Consumer confidence is a very short-term indicator while construction is presumably more long term. But is this correct? Residential construction is surely also pretty much a short- term measure.

It seems that American investors are confused and do not know where to turn. This, when there are so many other economic imbalances, is worrying and has implications for equity markets around the world.

According to Andrew Smithers, a London-based economist, the US's extraordinary number of economic imbalances entitles it to an entry in The Guinness Book of Records. Among these imbalances are low rates of personal savings, record levels of household and corporate debt, and enormous current account and budget deficits. As long as these imbalances persist, Smithers thinks monetary and fiscal inflation will provide only temporary relief.

Alan Greenspan, the chairman of the Federal Revenue, disagrees. As far as he is concerned, continued and rapid growth in productivity will flow through the system and increase corporate profits - which are still conspicuous by their absence.

Like Smithers, I am sceptical. In an environment that has never been more competitive, firms have no pricing power and their only option is to cut costs - hence the new phenomenon of "jobless growth". For firms to survive, they have to pass these savings on to consumers in the form of lower prices.

The Economist magazine reports that, according to the US national accounts, corporate profits rose by only two percent for the year ended March 2003. If this is the case, why have US equity prices rebounded strongly in recent months? They have surely gotten ahead of themselves.

Until share prices reflect fair value, there cannot be a sustainable change in what remains a bear market.

As The Economist says: "To take hold, rallies need support from profits and cheap valuations - investors should take note."

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