If the first rule of investing is "Don’t fight the Fed" then investors and traders should steer clear of homebuilder and REIT stocks. Make no mistake, as his remarks from last week indicated, Chairman Alan Greenspan has a bead on rising housing prices.
There’s an eerie similarity between Greenspan’s remarks in 1999, as the Federal Reserve began increasing interest rates to stem the Internet stock bubble, and those he made last week at the annual Federal Reserve Bank of Kansas City symposium. The only difference is, last week, Greenspan targeted rising home prices instead of rising equity prices.
I have included key excerpts from speeches in the two interest tightening cycles. The first quote comes from mid 1999, after the Federal Reserve first raised interest rates. The second quote comes from last week. And in case your "Fed-speak" is rusty, I’ll summarize. Greenspan essentially believes that excessive increases in prices (stocks, bonds or homes) are bad because, when they reverse, they negatively affect all other parts of the economy. Therefore, he believes it is better to pop the bubble through tighter monetary policy, than let the market run its course.
"Equity prices figure importantly in that forecasting process because they influence aggregate demand….Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or deflate emerging bubbles, we would be better off….The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs. It is the job of economic policy makers to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."
— CHAIRMAN ALAN GREENSPAN, Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1999
"The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power….Such an increase in market value is too often viewed by market participants as structural and permanent….Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
If we can maintain an adequate degree of flexibility, some of America’s economic imbalances, most notably the large current-account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment."— CHAIRMAN ALAN GREENSPAN, Kansas City Federal Reserve Bank Symposium, August 26, 2005
Since short term interest rates are the Federal Reserve’s only weapon to fight bubbles, the Chairman’s desire to defeat the "housing boom" will have consequences for the entire economy. However, it will have the most consequence for the home building and REIT sectors.
Homebuilder stocks, as measured by the Philadelphia Housing Index (HGX), are already nearing important long term support as shown in the weekly chart. A break below the 515 level would indicate a move to the next level of support at 450.
Several components of the HGX index have already broken short-term uptrends and are poised to retreat to longer term support. For example, Toll Brother’s (TOL) has already broken its first rising trendline at $50 and looks to be headed for a test of the longer term trend around $35. While it is sitting on some minor support at current levels, the risk to reward seems to be skewed to the negative side.
REITs, which are even more closely tied to interest rates than homebuilder stocks, could also have a tough time. The Dow Jones REIT Index (DJR) is forming an ominous looking long term rising wedge, which typically breaks to the downside.
Despite his penchant for rambling, Greenspan couldn’t have been clearer in his message last week. Investors and traders should take heed of Greenspan’s remarks because equities tied to housing demand could be in for a difficult time until the Federal Reserve is satisfied that housing prices have begun to decline.