This is my personal blog. Travel, financial and political observations. Notes to myself and my friends. Content development for my monthly newsletter, Porter Stansberry's Investment Advisory (www.stansberryresearch.com).

Monday, March 06, 2006


Rising mortgage rates have finally taken the equity piggy bank away from the deadsumers.

Rising commodity prices have destroyed all of their wage gains since 1995. Manufacturing has been gutted by foreign competition and now India is beginning to take white collar jobs too. Sooner or later people with huge mortgages and declining real wages who face strengthening foreign competitors are going to have to tighten their belts.

I think the “tipping point” is happening right now.

Let’s take a look at the evidence. The story has three parts. First, wages and savings are NOT responsible for the huge growth in consumer spending since 2003. That’s because wages haven’t kept pace with inflation and the savings rate has been in decline for more than ten years. Second, the rise in housing prices (fueled by huge increases to outstanding mortgage debt) gave U.S. consumers the ability to spend far more than they earned through refinancing their homes and cashing out equity. Everyone knows this anecdotally and the statistical evidence of it is overwhelming too. The game ends when mortgage rates rise (killing the ability to refinance) and housing prices cool. That’s when the “deadsumer” will have to retrench. They’ll simply have no more money to spend.

Here’s a chart of non-manager wages in the service industry and manufacturing wages (80% of all wages paid in the U.S.) since November 2001. The big jump higher in November 2005 is an anomaly: the government’s statistical body, the BLS, says that inflation fell in November (yeah right). Bottomline: incomes aren’t growing for the vast majority of Americans, even if you accept the government’s inflation figures.

Next, the surge in consumer spending over the last several years couldn’t have been based on savings (i.e. wealth), because as wages have been falling, U.S. consumers have been spending more. The savings rate has been decimated. You’ve seen the chart (below, left) below many times before, I’m sure. It shows that savings have declined, in almost a straight line, since 1985 and that the savings rate has been negative for most of 2004 and all of 2005. A negative saving rate means that “deadsumers” are spending money that don’t have – a condition that can’t last very long.

So…where did the money come from?

Simple, mortgages. Total outstanding mortgage debt rose from $6.6 trillion in 2000 to $11.3 trillion by the 3Q of 2005.

Outstanding mortgage debt nearly doubled in five years!

Total household borrowing increased from $6.9 trillion to $11 trillion in the same period – a 59% increase. The increase in mortgage leverage led to a rapid increase in the prices of existing homes. In fact, the prices of homes that were sold and re-sold grew at a much faster pace the price of brand-new homes (see chart below), clear evidence that much of the boom in housing has been caused by additional debt.

With the incomes augmented by additional mortgage debt turned into cash via refinancings, Americans went on a huge spending spree. The share price of retail stocks (below, left) shows what happened: up, up and away. Standard & Poor’s maintains a good index of retail businesses – about 35 companies like Home Depot, Bed Bath & Beyond, Big Lots, Costco, Dollar General, etc. (You can see the whole list here: http://www.analyzeindices.com/ind/retailers.htm).

These are big, big businesses – not the kind of stocks that should jump around like Internet stocks. But the average stock in the index has doubled since 2003!

Keep in mind, that’s the average. Some companies, like Sears Holdings, have gone up much, much more. Since early 2003, shares of Sears Holding have gone from around $12 to as high as $150 – an increase of over 1000%.

Sears Holdings was originally the remnants of Kmart. It emerged from bankruptcy in early 2003. The hedge fund manager who owned a majority, Eddie Lampert, sold off some of Kmart’s real estate holdings and got investors excited, which drove up the share price enough to allow for the acquisition of Sears. Ironic huh...a hedge fund manager uses the real estate of a retail company that’s being pumped up by real estate-inspired spending to acquire more retail locations. I wonder what will happen to Sears’ share price when the mortgage-spending bubble bursts?


My final point: the party is coming to an end.

Mortgage rates are rising. Housing prices have stalled and will soon decline. New home inventories are building. Consumers are beginning to pull back.

I see this most vividly in the results of two companies. First HouseValues Inc., which is an internet business dedicated to helping realtors sell houses, fell apart last week when it lowered its earnings guidance for 2006 from $0.14 per share to $0.04 per share. The stock fell more than 30% in a day.

Of course, you don’t have to go far down the quality spectrum to see that housing is starting to cool. Tollbrothers, the homebuilder famous for its McMansions, has reported falling sales trends since last year. Orders for new homes in the 1Q of 2006 are down 29% since last year!

Even more worrisomely, 8.8% of the homes it had sold but not yet delivered were canceled – considerably above the company’s historic 5% cancellation rate.

What’s behind the sudden drop in demand for homes and for home selling services…? Rising mortgage rates, of course.

Fixed rates have moved from around 5% in early 2003 to over 6% today. Adjustable rates have moved much more, in percentage terms, from 3% to over 5%. And a bunch of those adjustable rates will “reset” this year, costing consumers a lot more cash in interest payments.

As you can see from the S&P retail index above, retail stocks haven’t begun to feel the pressure that’s already apparent in the housing market. But other kinds of businesses that depend on large amounts of discretionary income have begun to feel the impact – most notably providers of online secondary education.

The biggest of these companies, Apollo (APOL), has grown rapidly over the last five years as white collar workers seeking MBAs and higher salaries paid top dollar for convenient (and easy) online education.

But now Apollo – after years of outstanding growth – is suddenly a company in trouble. Its CEO left abruptly in January. It has missed its revenue targets for the last five quarters in a row. Its allowance for uncollectible tuition increased 120% year over year, to $20.1 million (3.2% of all revenues!). The company acknowledges that this bad debt figure will increase throughout this year.

Apollo’s new CEO will not give revenue guidance, will not comment on the total number of students enrolled currently and has withdrawn this year’s earnings guidance. A company like Apollo, with a steady growing business shouldn’t suddenly hit a wall of this magnitude unless something bigger is affecting its market. And that something bigger is easy to see: consumers can no longer afford big ticket items like Tollbrothers’ houses and online private colleges.

The chart above shows Apollo's stock price compared to the S&P retail index. Will retail follow Apollo down the way it followed Apollo up. I bet it does. And I wonder how this trend will affect buyers of other types of expensive online information…like newsletters…

We’ll see.


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