Third Quarter 2006 Review

Posted on October 11, 2006 by David Laidlaw 

Many of the economic worries that caused the financial markets to drop during the second quarter abated over the last three months. Energy prices decreased significantly with oil declining by roughly 25% from its peak in mid-July. Gasoline prices also dropped since there is a glut of gasoline currently in storage. Inflation worries have decreased as the Federal Reserve stopped raising short-term interest rates with the expectation that economic growth will slow and thus ease the pressure on rising prices. Finally, the consensus view is that there is less likelihood of a spreading conflict from the Mid-East. We do not share this view since the global community has done nothing to deter an increasingly assertive Iran . Regardless, common stocks rebounded impressively.

We believe that it is vital to monitor the impact of declining home prices. The current data demonstrate the magnitude of the slowdown. During August, median housing prices decreased 1.7% compared to last year. This represents the first correction in over a decade. Home sales during the month of August were 14% lower than last year and new housing starts also declined precipitously.

Most market strategists predict that housing will continue to be weak for the next six to twelve months, but that prices will firm next year. “This is the price correction we’ve been expecting – with sales stabilizing, we should go back to positive price growth early next year,” commented David Lereah, the chief economist for the National Association of Realtors. We think the downturn will be more protracted since appreciation was so powerful. We also don’t believe that there is a broad enough understanding of the fact that real estate, as with any asset class, can experience long periods of decline.

However, our views regarding the economy and consumer spending are less bearish. Employment and wages continue to grow as is normal during this stage of an economic expansion. We still believe that these positives plus lower fuel costs will cushion the blow from decreases in the housing market.