How Far Will the Government Allow Home Prices to Fall?

Data out yesterday confirmed one of the Fed’s greatest fears – housing prices are double-dipping. The S&P Case-Shiller Index of 20 major metropolitan areas fell for the third straight month in October, taking the index back to its lowest level since April 2010. And while the index is still 4.4% above the April 2009 low, the new trend suggests that we may easily test those lows in the months to come. The deteriorating housing situation begs the question: How far will the government allow home prices to fall? An article from today’s Wall Street Journal said “With home prices sinking, lawmakers and the Obama administration face intense pressure from the real estate and banking industries to maintain some federal support.”

I have no doubt that the Federal government will continue to enact policies designed to support housing prices, but it is getting harder to figure out what those policies might be. The government already guarantees about 90% of new mortgages. Quantitative easing by the Fed has taken mortgage rates down to very low levels. Foreclosure moratoria have reduced the flood of homes on the market. The list goes on, but we still find ourselves with falling housing prices. We still have a massive suppy of homes in the foreclosure pipeline. We still have banks that are unwilling to assume the risk of new mortgage loans. And we have recently seen a spike in mortgage rates which will dramatically reduce housing affordability. How does anyone expect this situation to improve absent some new, drastic and very costly government initiative? Will there be the political will or public support for some costly new program?

Housing and employment remain the missing links in the economic recovery. The continued weakness in these areas is being ignored by the average pundit who predicts accelerated economic growth and a booming stock market in 2011. Yesterday’s Consumer Confidence reading, which came in at a well-below consensus estimate of 52.5, suggests that despite strong retail sales over the holidays, consumers are still not feeling good about their individual circumstances. Given that close to 70% of GDP is consumer spending, we remain a little more cautious than the “average pundit”. Ours is an economy that is still very much on shaky ground, and employment and housing are the keys to a sustainable recovery. For our part, we are not yet declaring victory.

We are in agreement with the consensus on one issue: large-cap, blue chip multinational companies offer strong value and should outperform in the year(s) to come. We would continue to own stocks in companies that offer reasonable upside in the now-consensus best-case scenario, along with strong downside protection should waters get choppy again.