As a result of the current loose monetary policy and additional stimulus coming down the pipe, “imbalances” within the economy are starting to form. BofA predicts a 10% drop in stock prices.  What are other experts saying on the stock market?  How will this impact real estate if there is a stock market drop? What does this mean for mortgage rates?

 

What are the experts saying about the stock market?

  • Bank of America: “ Bank of America was ringing alarm bells over equities on Friday, as it warned a correction is looming. “3R’s of rates, regulation, redistribution are the historic catalysts that end bull markets & bubbles…we say all ’21 events, not ’22, and all spell lower/volatile coming quarters/years,” said Michael Hartnett, chief investment strategist at the bank. (Marketwatch)
  • Goldman Sachs: “While improving data is good for the economy and overall recovery, “for equity valuations, higher rates would reduce the justification for multiples that are extremely elevated in absolute terms but attractive relative to bond and cash yields,” analysts at Goldman Sachs wrote in a Feb. 12 report. (Fortune Magazine)
  • Money Morning: “Since the lows of last March, the S&P 500 index is up about 75%. Even if you go back to before the COVID-induced stock market crash, the S&P 500 is up more than 15% and is not far below its all-time high. That takes you to the plainest argument for a stock market crash – companies are simply overvalued. The Shiller P/E ratio is over 35 right now – its highest level since the dotcom bust in 2000. To put that in perspective, the average Shiller P/E over the past 148 years is 16.78; valuations are more than double the historical average.”

What could cause the bubble to pop?

I foresee two primary factors that will alter the stock market: a rise in bond yields and general “frothiness” in the stock market as income does not justify valuations.

  1. Interest rates: This is the biggest risk to the stock market, as rates rise stocks become “relatively” more expensive to own.  US Bank did a nice article on this:

“In contrast to bonds, interest rate changes do not directly affect the stock market. However, Fed actions can have trickle-down effects that, in some cases, impact stock prices.

When interest rates rise, banks increase their rates for consumer loans. In theory, this means there’s less money available for consumer spending. Also, increased rates for business loans can sometimes cause companies to halt expansions and hires. Reduced consumer and business spending can both lower the value of a company’s stock”

  1. High Price to Earnings Multiples: The stock market is trading at it’s highest level since the 2000 dotcom bust.  With valuations so high, earnings must be stratospheric to allow stocks to continue their upward trajectory.  Unfortunately, there are allot of variables (including higher interest rates) that will make it next to impossible for the stock market to continue trudging much higher.

What does this mean for real estate?

With the stock market teetering towards a peak, interest rates beginning to rise, and additional stimulus almost a certainty we are at a precarious stage in the real estate market.

  1. Residential Real estate
    1. Near or at the peak: with rates rising and the rotation from stay at home to going somewhere housing is somewhere near a peak.
    2. Houses become less “affordable”, Not only are house prices near historic levels, but buyers will also face a double whammy as rates rise houses become even less affordable to buyers as the payment is higher. N
    3. Do not see a cliff drop: Although house prices are at historic highs in many markets, I do not see a 2008 repeat due to better underwriting and low inventory.
  2. Commercial
    1. Cliff drop: Many commercial property types from retail to office are in for a rough ride.  As rates rise, mortgage payments increase.  At the same time demand for many property types is at historic lows which will put further pressure on commercial property prices.  Hang on to your saddle as commercial property has a rough road ahead.

A much larger problem in the next recession/correction.

It is always good to look at past recessions to get a sense of what could happen when there is another cycle.  In past recessions/contractions, two things happen that soften the blow to the economy.

  • Interest rates decline: the federal reserve will drop interest rates during recessions to spur borrowing, investing, and economic activity. The drop in rates by the federal reserve will filter through the economy in the form of lower borrowing costs to both consumers and businesses.
  • Additional stimulus from the government: At the same time the federal reserve lowers rate, there is typically a stimulus package to further help the economy which could include direct payments to certain taxpayers, reductions in taxes, increased government spending, etc…

Unfortunately, in our current environment we have a problem with implementing the two items above.  In today’s market rates are already at rock bottom lows and there is not much room to go down further unless the federal reserve begins a policy of negative rates.  Furthermore, which so much stimulus and large deficits there likely will not be as much of an appetite for a large stimulus when the economy needs it.  Without these two tools available the next recession could be considerably tougher to emerge from.

What should the federal reserve do?

Although Mr. Powell, the head of the federal reserve, has yet to reach out for my insights, maybe he should . The federal reserve is always a day late and dollar short on economic policy.  The fed is focused on metrics after the fact as opposed to forward predicting metrics.  This gives a false sense of the market and where the market is heading.  Inflation is starting to pick up and demand will quickly rebound with vaccines.  Furthermore, the upcoming stimulus will further the demand side.  The federal reserve should be in front of the curve and relay to the markets that rates will rise gradually to help prevent the froth from forming and give them room to react before another downturn while at the same time helping to temper the current exuberance.

 

Summary

Regardless of what the fed is saying or doing to try and keep low interest rates, the market is not buying it.  10-year treasuries have been on a steady march higher and will no doubt go even higher with the recent stimulus bill.  The sharp rise in rates will cause a “reset” in the stock market along with a slowing of the residential market.  Unfortunately the federal reserve and Congress will have little ammunition to fight this next slow down with the federal funds rate basically at zero already and little appetite in Washington for further stimulus which could prolong any slowdown we have coming.

 

Additional Reading/Resources:

 

  1. https://www.marketwatch.com/story/get-ready-for-a-10-stock-drop-driven-by-the-3-rs-warns-bank-of-america-11611926024
  2. https://www.usbank.com/financialiq/invest-your-money/investment-strategies/how-do-interest-rates-affect-investments.html
  3. https://moneymorning.com/2021/02/23/how-we-know-a-stock-market-crash-is-coming-in-2021/
  4. https://fortune.com/2021/02/22/stock-market-outlook-pullback-s-andp-500-spx-decline/
  5. https://fortune.com/company/goldman-sachs-group/
  6. https://www.reuters.com/article/idUSKBN2AJ0YD

 

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending.  Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine,  The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.

 

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