It's Still Going to Get Worse

The late value investing legend John Templeton used to say that the best time to buy is at the point of maximum pessimism. And he acted on that belief. In 1939, after 10 years of an economic depression and with war looming, Templeton bought $100 worth of every stock selling for less than $1 a share. He achieved 300% returns on that investment in four years.

Perhaps Templeton would be warming up his buying gloves right now.

Or maybe not.

Glass half-full?
The collapse in the housing market kicked off this crisis, and there are some reasons to believe that we're near or past the halfway point in the decline. Though it's risky to make generalizations based on monthly trends in a seasonal industry, on a month-to-month basis, the rate of decline of the Case-Schiller housing price index is slowing.

What's more, the real estate market is finally starting to approach its fundamental value. Just as the value of a stock is a function of its discounted cash flow, the economic value of a house can be reasonably approximated by discounted cash flow that could be generated from renting that house. One would expect the ratio between the Case-Schiller Index and the Owners' Equivalent Rent -- the amount of money that homeowners would pay if they rented their houses instead of owning -- to remain roughly constant.

Indeed, from 1986 to 2000, this ratio fluctuated in a narrow range roughly between 1.1 and 0.9. When the housing bubble started inflating in 2000, the ratio began its ascent and eventually peaked above 1.6. Since then, the ratio has fallen to about 1.3. So, assuming a "fair" ratio is around 1.0, we're more than halfway to our destination.

Glass half-empty?
But even a recovery in real estate prices wouldn't solve this crisis, because the writedowns plaguing Washington Mutual (NYSE: WM  ) and most other banks have shown few signs of abating.

In the first half of 2008, we had four bank failures, more than in all of 2007. Since the beginning of July, four more have collapsed, including IndyMac, which represented the second-largest bank failure in U.S. history. Still, enduring eight bankruptcies is minor compared with the hundreds of thrifts that went under during the savings-and-loan crisis of the late 1980s, so this trend may have only just begun.

Nor is the market for mortgage-backed securities recovering -- it may actually be worsening. According to JPMorgan Chase (NYSE: JPM  ) the mortgage market has "substantially deteriorated" even since July. This turmoil has caused banks to tighten their lending standards, and doing so has made it more difficult for businesses and individuals to get loans. It's also putting a drag on the economy.

Don't expect government-sponsored enterprises Fannie Mae (NYSE: FNM  ) and Freddie Mac to pick up the slack by issuing new loans. In a recent survey by The Wall Street Journal, economists estimated that there was a 59% chance that the government will need to bail out one of these companies.

Simply empty
The problems have spread beyond real estate and financials into the broader economy. The unemployment rate is at 5.7% -- the highest it's been in four years -- and rising. As you'd expect during a credit contraction and a faltering job market, consumer confidence had descended to extremely low levels.

Even major consumer-facing companies have been affected. Retailers from Target (NYSE: TGT  ) to Limited Brands (NYSE: LTD  ) are suffering declining same-store sales. Google (Nasdaq: GOOG  ) missed earnings estimates last quarter, with the company's CEO noting that the economic environment has become more challenging. Starbucks (Nasdaq: SBUX  ) has had to scale back growth plans and even close some of its existing stores.

In normal times, this is where you'd expect the Federal Reserve to jump in and come to the rescue. But by keeping rates too low for too long and ignoring all of the warning signs, the Fed helped fuel the speculative borrowing that caused this crisis. Now, with inflation running at 5.6%, the highest rate since 1990, the Fed's traditional method of addressing the problem -- reducing interest rates -- could make things worse by further weakening the dollar and aggravating inflation.

Does it do nothing and risk more bank failures, higher unemployment, and a run on the dollar? Or does it lower rates to stimulate the economy but risk higher oil and food prices and the creeping destruction of wealth through inflation? At this point, it looks as though Alan Greenspan's smartest move was retiring before his chickens came home to roost.

Fill your glass
Luckily, you don't need to figure out how to save the economy. You just need to find great stocks. On one hand, all of this bad news makes that job harder -- we almost certainly haven't seen the end of corporate bankruptcies, so it's important to avoid blow-ups. On the other hand, it's now quite possible to find companies with huge competitive advantages trading at excellent prices.

Thus, you shouldn't abandon the market, but your focus should change slightly. For example, earnings are less important in this environment than balance-sheet strength. In turbulent times, a strong balance sheet both ensures survival and allows a business to gain market share when the competition falters. When the recovery finally arrives, the strongest companies will have become even stronger, and profits will follow.

The Foolish bottom line
Though it still seems that there's a lot of bad news to come, when we pass the point of maximum pessimism, the market could turn quickly. So although it's important to tread cautiously, it's equally important to take advantage of the opportunities that this market is offering today. Solid growth stocks that looked cheap six months ago look even cheaper now. It's unclear exactly when the market will turn, but investors at these prices could still profit handsomely.

Our Inside Value team recently reviewed all of our picks and have identified the stocks that we think will lead the way. With many of the stocks trading substantially below their fair value, we're feeling optimistic. You can read about them with a free trial.

Fool contributor Richard Gibbons has won the same number of Olympic silver medals as Michael Phelps. Richard does not own shares of any companies mentioned. The Motley Fool owns shares of Starbucks. JPMorgan Chase and Limited Brands are Income Investor recommendations. Limited Brands and Starbucks are Inside Value picks. Starbucks is also a Stock Advisor selection. Google is a Rule Breakers recommendation. The Fool's disclosure policy is not for the faint of heart.


Read/Post Comments (23) | Recommend This Article (53)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 19, 2008, at 3:42 PM, birdtard wrote:

    After it is all said and done, the MotleyFool article still has told us nothing as usual.

  • Report this Comment On August 19, 2008, at 4:47 PM, John53705 wrote:

    "Just as the value of a stock is a function of its discounted cash flow, the economic value of a house can be reasonably approximated by discounted cash flow that could be generated from renting that house."

    I may be missing the point here, but it seems to me that the value of an owner occupied house is clearly higher than the amount it will rent for unless we make some pretty important assumptions that were unstated in this article.

    Appraisers use a combination of income, comparable sales, and replacement cost to estimate the value of a house. This allows a number of important factors to be considered at the local level. If we want to find a regional measure of value to evaluate as the author does, don't we at least need to factor in the percentage of owner occupied homes vs renter occupied in that region? The value of the home would seem to be heavily influenced by the proportion of rentals to owner occupied units in that region.

    The rental experience is far different from the ownership experience, and people will pay something for the ability to make their own decisions and to invest time and money in the asset if they own it. Owner occupied homes routinely sell for much more than rental houses in our area. I suspect largely because you are buying a share of a neighborhood of a much more desirable nature as part of the bargain.

  • Report this Comment On August 19, 2008, at 5:00 PM, temp2290 wrote:

    Owner occupied homes sell for more because their prices are bloated, nothing more. People will pay more for something that they believe has value as an investment. But that was a function of the times we used to live in, where houses actually did appreciate.

    The very idea of "homes always appreciate" is just a gimmick by realtors. If you do the calculations, you're better off renting if you don't plan on owning for 10+ years and you don't forsee a substantial appreciation in your location.

  • Report this Comment On August 19, 2008, at 5:09 PM, taxbiter wrote:

    As usual, another worthless opinion followed by the sales pitch.

  • Report this Comment On August 19, 2008, at 5:19 PM, pink3 wrote:

    I think the key phrase is "economic value"--not emotional value, not social value. The deflation of the housing bubble shows that what someone is willing to pay for a house (or more accurately, what a bank is willing to loan someone to pay for a house) does not necessarily equate to its real value. On the other hand, when someone writes a rent check month after month, without benefit of "other people's money", you can rely on that number as a true reflection of the market value of the house. So I would rather go with a loose rule-of-thumb ratio based on people spending their own money on an ongoing basis, versus appraisals with all of their opportunity for funny business.

  • Report this Comment On August 19, 2008, at 5:41 PM, TDRH wrote:

    The housing market and many stocks within the market will overshoot the bottom. The $7500 loan from the US government will not help. Key factor is the historical relationship between the median household income and median home price. Until this is restored prices will continue to fall, foreclosures will continue to rise, and banks will continue to fail.

    This is a classic shift in demand from Econ 101. Without alternative financing the prices have to fall to the level where buyers can afford the homes.

  • Report this Comment On August 19, 2008, at 6:04 PM, tumachar wrote:

    Heres one though as long as "Fool" will remain bullish market will not bottom, after all Fool is now conventional wisdom (you can see that by the number of people who read fool.com).

  • Report this Comment On August 19, 2008, at 6:10 PM, tumachar wrote:

    The author points that ratio of Owners Equivalent rent and Case-Shiller index is at 1.3, between 1986 and 2000 it ranged 0.9 to 1.1. I would say if something is falling from that height, it will not stop at its fair value, it should become a value, i.e it will go below 0.9 to become value. Even 0.9 is another 30% fall from here.. Way to go..

  • Report this Comment On August 20, 2008, at 12:28 AM, rbgibbons wrote:

    Turnachar, when discussing the economy, the most optimistic thing I say is that housing might be past the halfway point. Then I note that almost all the evidence I've seen points to the financials getting worse, and that the contagion is affecting the rest of the economy. Then I say that I can't really see any way to solve the problems.

    Do you really consider the article bullish?

    The main reasons I'm optimistic are:

    1. America is resiliant, and will probably recover eventually. That recovery might be a couple years away, but we're closer to it than we were a year ago.

    2. The timing of the recovery is uncertain, but I'm much more confident that certain stocks are undervalued, and that undervalued stocks will eventually return to their fair value.

    For those who think the article has no value, I'm surprised. I think it's a reasonably summary of how bad things are right now and why it will be hard for the Fed to solve the problems. But, even if you follow the market closely and don't need a summary, I would have thought the housing information would provide value.

    I find the idea of the fundamental value of housing very important in determining where the housing bust at least has a chance of stopping, and I also find it noteworthy that, amid all the panicky housing headlines, the rate of decline in housing prices is slowing.

    What sort of things would you like me to write that would add value?

    Richard (AKA the author)

  • Report this Comment On August 20, 2008, at 2:41 AM, 4673123 wrote:

    What crap, what gives vaule on a home is if you can finance it. Lower the rate more purchesing power, provided you dont lie about your income to the lender. Its simple if no lenders are lending the the vaule of the home,s go down. The only thing that bust the housing market if Lenders dont lend, Or borrowers dont pay back the loan. What made the last Bull market was the sub-prime r e loans that made it easy to fianance your home. And take the cash and spend it on things that kept you up with the Jones. Like Afred E. Newman says "WHAT ME WORRY"

  • Report this Comment On August 20, 2008, at 12:11 PM, hifibri wrote:

    I thought it was a good article. Richard, the author was speaking in general terms in determining value on a National scale. Two other advantages of owning vs. renting is tax deductibility of interest and the building of equity, both of which are worth paying a premium for as compared to renting. TDRH and 4673123 make astute observations that it's not the cost of the house that matters, it's the cost of borrowing the money to buy the house that matters. Especially noteworthy was the enlightened statement that the FED was the reason for the boom and bust. But it's unfortunate that folks like 4673123 bought into uninformed media headlines written by uninformed journalists listening to uninformed politicians that subprime loans are solely to blame. Subprime only make up about 15% of all loans. The great groundswell of demand came from PRIME loans due to cheap money made available by the FED for such a long time. Research the FED's rate policy starting in 2001 to see for yourself. The very definition of subprime means these are risky loans FOR THE LENDER, and as such will be the FIRST to fail when things get tough but they didn’t CAUSE the initial weakness in the economy. The boom and bust in the national housing market wasn't caused by bad real estate agents, bad loan officers, or bad appraisers. It was the availability of incredibly cheap money for an extended period of time that created a frenzied, overwhelming demand. Legislators are calling for more legislation to prevent this from happening when it was the FED trying to manipulate the economy to overcome underlying weaknesses in the economy that caused it - and it worked - for a while. The Dallas FED has even stated that they misread inflation and had lowered rates too far. There were other factors that exacerbated demand like the fall from favor of the stock market after the crash of 2000 that made real estate such an attractive investment - especially with such low rates. Around 2004 more people owned investment property and second homes than any other time in history - do you think this helped create demand? After the FED started raising rates the over inflated prices could not be sustained at the same time the underlying weakness in the economy persists only now exacerbated by higher energy costs. As if banks struggling to work through this being overly cautious with making new loans, new legislation is further choking the availability of credit. In addition, the additional cost to lenders and brokers to comply with the new rules is raising the cost of borrowing even higher. Legislators are trying to cure the symptom (foreclosures), not the cause (economic issues). One example is the new legislation that bans down payment assistance programs for FHA borrowers. This will take another whole segment of the population out of the home buying market. If the low end of the housing market suffers the whole market suffers.

  • Report this Comment On August 20, 2008, at 12:39 PM, biotechmgr wrote:

    Agree with birdtard, another MF article ending with a "warning" you could miss the next profit wave. On the contrary...Staying out, you will miss the next wave of losses.

  • Report this Comment On August 20, 2008, at 12:59 PM, FOOLBEFREE wrote:

    ->Keep some powder dry, have some money ready for an eventual market panic. Bear markets usually end after a panic, which it has not happened yet. When it happens, hit the fast ball and buy the good stocks at low prices such as DIS, AXP, COST, BRK.B , etc. and some ETFs DIA, SPY, IWM, QQQQ.

    ->Inflation will stay high for some years and it may be a good idea to buy some commodity stocks to diversify and protect against inflation. China will continue growing at 5-7% a year for several years. I like FCX, XTO, PBR, RIO. CGMFX, the CGM Focus fund, has done great over the last years because they have some commodity stocks.

  • Report this Comment On August 20, 2008, at 4:56 PM, 4673123 wrote:

    Hifibri, I dont read the headline's I make them on sub-prime. Who do you think is the manager on the headline.

    http://www.thestreet.com/story/10421567/1/aig-lending-unit-c...

  • Report this Comment On August 20, 2008, at 8:27 PM, hifibri wrote:

    Hi Nat(?), I don’t know the answer to your question, but if you write articles on subprime I did not mean to insult you. That’s a fine article of another subprime casualty. The point is without a macro view of the problem blame gets inappropriately assigned. I'm not defending subprime nor implying that subprime is not without fault in the mess, of which there are many causes (and I don't have the time to get into all of them here because I never learned to type so well), and it is now certainly a contributing factor of declining values. The extremes in subprime lending were a result of factors that came before it. The FED, through economic engineering created the conditions that created the housing bubble. Subprime has been around for decades. Only after a period of tremendous appreciation due to low PRIME rates did subprime lending become the most reckless. It was the good past performance of these products due to the great appreciation that had the investors so sure of their future investments, but it had to end sometime, and it did after the FED started turning off the spigot of cheap PRIME money which caused demand to wane. Prices had gotten so inflated it did not take a big change in rates to stop the buying demand of PRIME borrowers which caused appreciation to stop. Sure, subprime helped increased deman too, but it only made up about 15% of all loans written at the time which was maybe 5% more than in previous decades. The market was affected much more by PRIME loans. Subprime by its nature was the first casualty and because of that, it gets the blame, but it did not cause the housing bust, it was just the first symptom of a sick market.

  • Report this Comment On August 21, 2008, at 2:49 AM, 4673123 wrote:

    Iam sorry hifibri, it was me not Nat, I was the slaim ball that gave him the crap on AIG & AGF. I didnt mean to come across like that. You make very good points and you seem to know your facts about the sub-prime %. The problem is that the brokage house's and the banks that are in hot water put to much focus on the bottom line and never sat down and looked at the downside risk with this paper. To make matters worse they loaded up with to much of this paper on the books. I knew that this paper would take down AIG. I was written up 2 times by my supervisor, I would voice my concern in mettings about when the rate would go up on these homeowners, that most likely they would default. He said I was to negative on are loan products, and how could I be a good sale's person and lead the sales people in my branch. That sums up the mind set for are division at AGF. I came over to this company at a time when r e loans were not even on the books yet. Now you can see that upper management knew nothing about r e loans. There background was just consumer financing i.e. personal loans at 28%, auto,boat, airplan, trucks and so on. Plus most of the customer's lived from paycheck to paycheck. I hate to say it but AIG is in trouble until this paper is off the books. But what do I know, I bought 340 shares of WM 2 weeks ago, can you say goverment bail out or BK.

  • Report this Comment On August 22, 2008, at 11:08 AM, fibreoptik wrote:

    Blah blah blah... same old, same old.

    Not recommending this post.

  • Report this Comment On August 22, 2008, at 4:23 PM, fOOLSONPARADE wrote:

    The day Motley Fool starts talking about stocks to short or buy puts on is the day they start offering a useful service. Until then it's just another cheerleader with an agenda. FLASH: We are in a bear market and it's gonna be a long one!

  • Report this Comment On August 25, 2008, at 3:40 AM, LifesABeach310 wrote:

    Let me see.. I will write this as a native of Southern California. The way I have seen things is that in the better parts of So Cal, real estate started rising in value around 1996. I am sure in different parts of the country the year the housing market started taking off may have been a bit later. As the stock market started tanking due to tech stock meltdown, it only seemed to help housing as people pulled money out of stocks and it seems invested a good deal of gains into their house, a 2nd home or investment properties. There was an added benefit that interest rates started falling which made money cheaper. Cheaper money continued to help home values rise because people could afford larger loans. Then truly brilliant financial minds started stepping in and I believe their common thought process was something like: "Hey, it's great that money is getting cheaper but what we really need to do is make it readily available to anyone that wants to borrow it!! The greater borrowing will stimulate housing and the economy further! Good for housing, banking, buillders, and all the new Donald Trumps of the world! Let's make 100% financing availabe to just about everyone. We will come up with all sorts of mortgage products to allow people of all credit histories and earning power (i.e. let them state what they make and how much cash they have) to obtain a mortgage on just about anything that has 4 walls and a roof. " Home prices soared like the tech stocks of the 90's! woo hoo! Equity! Equity! Equity! Now the financial geniuses said, borrower your newly found equity! What good is equity if you don't spend it! Consumerism flourished!! The economy was smoking hot and the Prime Rate was so low the money seemed to be free. The results were beautiful, the financial geniuses congratulated one another on a job well done. The way I see it, homes are similar to art. There is no underlying value other than what people are willing to pay for them. The most valuable real estate in the world can be reduced to essentially zero due to a natural or man-made disaster of suffienct proportions. Ultra cheap money has resulted in massive inflation in most sectors during the last 8 years. I continue to be baffled at how people make financial decision from their gut. The best part is that a home purhcase is the largest financial obligation that most people will encounter in their lives and a huge percentage of the population wanted to buy a home even though they couldn't afford it once the payment was presented to them, but they feared missing the 'investment opportunity'. Then the lenders happily lent them money even though any ability to repay the loans clearly could not be presented sufficiently via documentation. If the economic and stock market boom we have seen during the last 5 or so years was heavily contributed to by the expanse in the housing market, and now we are seeing that credit markets are extremely tight, more banks are likely to fail, the government will have to bail out Fannie and Freddie possibly, doesn't it seem quite reasonable that we should see a dramatic market pullback, to levels substantially below where we are today. Today we have realtively cheap money still, but credit is extremely tight and getting tighter. Tight credit I think would be a major barrier to economic expansion. Additionally, low rates are ocntinuing to fuel high inflation putting more pressure on households. Companies it seems are mostly cutting back, unemployment is rising, government spending is out of control, and I just want to know what fundamentals people are looking at that make them think any kind of real estate or stock market recovery is coming up shortly as soon as "Mid 2009", why does that time period seem to be so commonly quoted. Readily available cheap mortgage money caused the housing market to soar. Highly unavailable mortgage money with rates that are climbing I would think could only continue to cause housing to fall further and substantially so. With such overall economic weakness, valuations on most stocks still seem to be abnormally high. Personlly, I feel be a pessimist, let housing and the markets fall as much as needed without trying to prop them up with salesmanship and intervention. At the end of the day they will be more stable and we will make more money on the recovery in the long run.

  • Report this Comment On August 25, 2008, at 6:09 AM, journeywithme wrote:

    I agree that it is going to get worse. I attended an interesting event the other day about the current state of our economy and the future outlook. Scary. I summarized what I learned here: http://www.ourstockmarketjourney.blogspot.com/. Be well.

  • Report this Comment On August 28, 2008, at 2:51 PM, lquadland10 wrote:

    I need a good drop on my house price then I will pay less in taxes. I smell the blood on the street that you can't see yet. Buy now and pay in 5 years with no intress. Labor department under reporting actual is about 11.5 full and part time. 1.5 went from full to part time. More layoff's coming. Now that the dollar is (snicker) stronger and commodities come down then we will have to sell more for the same income. Yep oil will be higher soon when China buys to low cost oil it fill up their strategic oil reserve. Oh yea life is good.

  • Report this Comment On September 08, 2008, at 6:36 PM, MazonCreekRich wrote:

    "earnings are less important in this environment than balance-sheet strength."

    That phrase alone makes the article worth reading

  • Report this Comment On October 17, 2008, at 8:19 PM, StarWitchDoctor wrote:

    yeah, I thoght that one sentece was the gem as well and Im reading it in october.... seventeenth. Seems to me some companies have held out in thier incustries because of balance sheet strength. I think we need to realize that even though some of this is produced to make a profit (is there someone in the room that thinks this is wrong? - i find that difficult to believe, stockbuyers....) there are still pearls to pick amongst oysters.

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