The “R” Word Rears Its Ugly Head
11/08/2007 12:00 am EST
James Oberweis, editor of The Oberweis Report, worries that high oil prices and lower home prices will hit the consumer hard and could bring on a recession next year.
We are not pessimists. It’s just that we have nothing good to say. We’re struggling to grasp how—in the face of what appears to be an increasingly inevitable recession in 2008—the stock market continues higher.
Suppose that the specter of housing, high oil prices (aka Iran), and tighter credit come together in a climactic unhappy ending in 2008. We’d give that final chapter a title that starts with “R”. We think the case is worthy of consideration, and maybe even worth betting on.
As housing prices surged in the late 1990s and early 2000s, people boosted their spending faster than their income rose. In an appreciating housing market, increases in home prices added to home equity, from which cash-constrained households could withdraw a portion to fund current expenditures.
Nearly everyone agrees that depreciating (or even nonappreciating) home prices will curtail consumer expenditure. According to the Congressional Budget Office (CBO), most estimates of the housing wealth effect in United States fall within a range of 2% to 7% of extra spending.
We suspect, however, that the coming decrease in consumer spending will be much larger than a reverse of the CBO figures. Unfortunately, we believe people’s future wealth expectations were skewed to the upside by unrealistic assumptions regarding the future appreciation rate of their homes.
In the long run, housing prices adjusted for inflation have risen at less than 1% per year. Yet when Yale professor Robert Shiller surveyed Los Angeles residents about their projected annual rate of home appreciation over the next ten years, the average response was 14.3% in 1988, 13.0% in 2003, 22.5% in 2004 and 22.7% in 2005.
The 2005 number is particularly interesting: After the biggest bull market in housing ever, Shiller noted that residents believed that the next ten years would bring average annual gains of more than 20%. It’s not hard to imagine LA consumers reining in spending much more quickly if those expected 20% gains suddenly become losses.
In short, if we were CEOs of large US-focused consumer cyclical stocks, we might have a hard time sleeping. Reduced consumer spending is our number-one worry for growth in 2008. After all, [nearly $100-a-barrel] oil is hardly a growth catalyst.
Luckily, stock valuations based on historical earnings look cheap. Among our universe of small-cap companies growing faster than 30%, the average P/E based on trailing 12-month earnings is 28x, sharply below the average of the last five years of 37x.
But the P/E based on forward 12-month earnings estimates stands at 43x, which is the highest we’ve seen since 2003 and sharply higher than the five-year average of 30x. Remember, though it took awhile, Hamlet did eventually get his Claudius, and so might housing seek its revenge. Winds of caution are certainly blowing as we approach the New Year.