What should you do if the real estate bubble bursts?
Eric Fry - Mon 09 Oct, 2006
...Ms Stephanie Pomboy offers up this quirky pair trade as a way to play the US housing-induced consumer-spending slump...
- "Buy Hormel, Sell Starbucks," suggests Stephanie Pomboy, the freethinking mind behind MacroMavens, an elite Wall Street research service.
- Ms Pomboy offers up this quirky pair trade as a way to play the US housing-induced consumer-spending slump. Now that US home prices are falling, she reasons, American consumers will not only feel poorer, they will also lose access to the home-equity lines that have been fuelling their consumption.
- As a result, they will become less inclined to buy $5 espresso drinks, and more inclined to buy low-cost foods of various types.
Real estate bubble burst: Deflation
- "The deflation of the US housing market is sure to wreak far more havoc than its dot-com predecessor," Pomboy predicts, "shaking the very foundation upon which the US consumer and financial system (with its record real-estate exposure) now rest."
- If, therefore, the free-spending – but overly indebted – American consumer begins to spend a little less freely, which industries would feel the pinch? And which would benefit?
- Your editor would not quarrel with Pomboy's suggestion to short Starbucks, the purveyor of pricey coffee drinks, while simultaneously buying Hormel, the purveyor of inexpensive forms of "meat and meat by-products."
- But neither would he rush to implement this trade. As a hard-core Starbucks consumer, he could not easily imagine a financial condition so dire that he would abandon his daily cappuccino. (His children would go without shoes first). Nor could he imagine a household budget so stretched that he would purchase a can of Spam...and actually eat it.
- That said, he suspects Pomboy is on the right track, which is why he finds her second suggestion far more compelling: Sell financials; buy gold shares.
Real estate bubble burst: "Sell financials"
- The "sell financials" half of the trade is easy enough to understand. Demand for new mortgages in the US is drying up faster than a movie star in rehab. At the same time, delinquencies and defaults are increasing on the trillions of dollars of mortgages that that the lenders still hold on their books.
- "Contrary to popular perception," Pomboy writes, "the US banks have not shrewdly offloaded all their mortgage risk. They still hold $3 trillion in direct mortgage loans (or 43% of total assets) and have another $1 trillion in mortgage-backed securities, bringing their total real-state exposure to a record-high 55% of assets."
- Therefore, Pomboy would be a seller (or short-seller) of regional banks, credit card companies and sub-prime lenders. Simultaneously, she would be a buyer of gold and gold shares. Here's her thinking: As inflation fears give way to deflation fears, the Fed may begin slashing rates very soon.
- But the Fed's efforts will be for naught, "as over- extended consumers resist the cheap-credit bait." Even though the Fed's upcoming easy-money cycle will fail to revive the swooning American consumer, however, it will not fail to undermine the value of the dollar.
- As a result, gold will rally.
Regards,
Eric Fry,
for The Daily Reckoning
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