Another Story of Too Much Debt: Investing During Unsustainable Economic Conditions
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US-based investors cannot ignore the macro environment, and therefore must consider the consequences of our increasing indebtedness and its impact on capital markets. We can gain valuable insights into our fiscal problems from the housing bubble and the European sovereign debt crisis – lessons which every value investor should heed.
Our debt levels are unsustainable, and that creates unique investment challenges which impact how we are positioning our portfolios. First, however, let’s look at the housing bubble and the European sovereign debt crisis to understand how they relate to our fiscal situation.
Lessons from the housing bubble
Prior to the onset of the housing bust, one of the more telling sets of data which gave one a distinct sense of “something isn’t right here” was that of nationwide home equity. Home prices had more than doubled in the decade from 1996 to 2006, and with such an increase in prices it was natural to expect that home equity shouldhave also risen substantially. However, to the amazement of many of us at the time, home equity on a nationwide basis steadily dropped throughout the housing boom and reached its lowest level in decades as the housing market peaked in 2006.
Presented with this set of facts, it was fairly straightforward to conclude that the only possible reason for home equity to drop to decade lows at the same time home prices rose dramatically was if the amount of new mortgage debt was rising even faster than the increase in home values. Since home prices had doubled over the previous 10 years, this was an incredible circumstance. The amount of new mortgage debt needed to drive home equity lower while nationwide home prices doubled was enormous, in the trillions of dollars, and all this new debt greatly increased the risk to the entire market if home prices were to stop rising and start to fall.
As we all know today, the amount of new debt flooding the housing market during the bubble was indeed enormous. Fueled by all this new debt, home prices rose far higher than was sustainable by the economic fundamentals, such as income growth and demographics, which support home prices in more normal times. The higher prices rose, the more the housing market depended on ever-increasing debt just to sustain itself, and once that debt flow began to dry up the inevitable crash came.
Six years later, home prices nationally are well on their way back to levels which are sustainable, i.e., can be supported by underlying economic fundamentals. The most recent release of the Case-Shiller 20-city Home Price Index shows it declined to a new post-2006 low in January, and it is now down 34.4% from its peak. While it will take a long time for all the remaining imbalances (such as excess housing inventory) from the bubble to be worked through, the housing market is certainly headed in the right direction.
From a historical perspective, there is little about the recent housing boom/bust that is fundamentally unique – it was a debt-fueled bubble that eventually ran out of fuel and burst, similar to other financial bubbles in the past. This same dynamic has played out time and time again in the financial markets, and we are currently seeing it play out again – this time, at the sovereign level.