|Forbes.com, Spring, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
Federal Reserve chair Janet Yellen recently told Congress that flattening housing activity “could prove more protracted than currently expected.” Yellen’s comment immediately threw a Klieg light not just on real estate but on a host of other related topics affecting investors, not the least of which is interest rates.
If you didn’t immediately connect the dots, think of it this way. For most of 2013, minute ticks in housing measures seemed to signal a housing recovery was imminent. Now that we’re halfway through 2014, however, no such thing seems to be occurring. Without a housing recovery — which in turn would imply an economic recovery — there is less incentive for the Fed to rush about winding down its controversial “quantitative easing” policy, which helped pushed interest rates to record lows during the past five years.
Of course, the Fed has said all along it might reverse course if new developments gave it a reason to. Now such a reason has been explicitly named.
Yellen’s take on the housing market certainly squares with the available information which to date shows sales of new homes down 13% year-over-year and sales of existing homes — which is most of them — down 8%. Buyers seem scarce since applications for new mortgages recently hit a 14-year low.
You might have thought that equities in the housing sector might have moved down on Yellen’s comments. In fact, although the Nasdaq Composite Index fell over 13 points that day, the drop was tied to a 19% drop by Whole Foods Markets and a 6.6% loss by Yahoo .
Representatives from housing-related stocks were rather sanguine about Yellen’s remarks. “The pace of the recovery is slowing, but housing overall is doing pretty well,” said Spencer Rascoff, CEO of research site Zillow . Rascoff predicts home-price appreciation, which was in the double-digits for most of 2013, will slow to “more normal levels” of 3% to 4%, indicating a “reasonably healthy market” in his opinion.
Those without specific stocks to worry about seemed more pessimistic. Real-estate developer Sam Zell for instance said that he expects the homeownership rate — which peaked in 2005 at 69.1% and is currently about 65% — to fall to 55%, which would be the lowest level since the early 1950s.
Whether or not you agree with the basic rationale behind a negative view of housing, it’s certainly no reason to rush to dump stocks related to housing and real estate nor, by extension, the paint, furniture, appliance and other stocks which can show a close correlation to housing.
Interestingly, there are cases to be made for all three possible reactions to Yellen’s remarks vis a vis equities: Sell, buy or do nothing. Depending on investors’ timelines and needs, they may think about cycling out of housing stocks or at the least not putting more money into them at this time. Another stockholder may take the view that housing will eventually recover so now could be a time to buy equities in the sector at relative “bargain” prices. In the midst of all this, an investor whose portfolio is calibrated to his or her needs and risk tolerance and is performing to expectations couldn’t be blamed for making no changes at all.
Yellen’s remarks raised the prospect of a change in Fed policy if an unforeseen housing downturn materializes, but they also underscored what the Fed has said all along – that it might reverse course if new developments give it a reason to. It might be housing today, but what if it’s unemployment (or some other reason) tomorrow?
Here’s an interesting scenario: interest rates could stay low. So far, just about everyone has been wrong regarding the direction of interest rates. Yet, here we are, half way (or less) through tapering and the yield of the Ten Year Treasury is about 1/4% lower than it was at the end of December 2013.
What this means is instead of worrying about real estate, we should take a closer look at bond investments. Every expert thought that once the Fed started tapering, yields would rise and bond values would fall because of the inverse relationship between bond yields and bond prices. In other words, as interests rates drop, prices rise and vice versa. Bonds are subject to market and interest rate risk if sold prior to maturity and are subject to availability.
Let’s assume that interest rates stay at current levels. Given this assumption, bond investments should hold their value and will continue to earn whatever interest the yield of the bond provides. Yields are low, and the interest income earned will continue to be anemic.
It’s not ideal but so what? Unlike interest rates, inflationary pressures are starting to rise, which means that ‘Real’ income – the inflation adjusted income – received is even lower than you think, perhaps even negative.
Consider this: If professional money managers and institutions start to sell bonds even as interest rates remain steady, the selling pressure could impact bond prices.
I think everyone agrees that eventually rates must rise. Even if you’re a contrarian and really do expect interest rates to drop from current levels, there is still no objective reason to expect the value of bond investments will rise above their current levels.
This is where expert advice can really come into play. First of all, bond investments can be constructed in such a way that mitigates price swings using maturity dates, credit quality and other factors.
Second, there are viable alternatives to bonds that can provide a steady income stream, have a more positive long-term outlook than bonds currently have, and depending on the route chosen, may even guarantee the principal.
Just as with the observations on housing stocks, investors with different needs, time frames and appetite for risk face a selection of choices on what to do if Yellen’s bearishness on housing means a sustained low interest rate environment for bonds.