It shouldn’t come as a shock to you that California has a higher rate of inflation than the rest of the country. If we are to look at historical measures, what should the price of a California home be in 2007 accounting for inflation pressures? Using the CPI for California, which includes all urban consumers we can get an idea how fast housing prices have outpaced even California inflation which has a higher rate than the rest of the nation. Let us take a point in time where home prices were reasonable in California. We will use the base point of 1999. Let us take a look at a region that has seen some of the wildest inflation, Southern California:

CPI 1999 = 168.5

CPI 2007 = 217.4

How do we derive the current price of goods for today? We follow the following formula:

2007 Price = 1999 price X (CPI 2007 / CPI 1999)

2007 = $198,000 Southern California Median Home X (217.4 / 168.5) = $255,000

And what is the current median home price for the region? How about $425,000. Prices are currently trending lower from the $500,000 peak that was reached for the region. The question that exists for many is will prices come back down to inflation adjusted prices? That is yet to be seen but the trend is definitely pointed toward this.

Incomes not Keeping up

Why are you not feeling any richer even though you are making more money? It is the eroding nature of inflation and the fact that California is already in recession even though we do not have the official label as of yet and we will touch upon that later. Let us use the above formula again for the state and show how inflation is still eroding the purchasing power of current consumers:

California Household Income

2000: $47,493

2007: $54,385

CPI 2000: 174.8

CPI 2007: 217.4

2007 Income = 2000 Income X (217.4 / 174.8) = $59,067

Not a big difference but you can see that even though households bring in more than in 2000 the power of inflation has actually taken away more than $4,600 in purchasing power. The fact that housing has adjusted at a pace unseen and justified by a rise in incomes only points to the inevitable reality that prices will continue to come down further in the upcoming years.

What is a Recession?

Ronald Reagan, the once Governor of California and former President once said that “a recession is when a neighbor loses his job. Depression is when you lose yours.” This is a very accurate quote on how society perceives economic downturns and the way things are currently playing out, it seems like the economy is once again going to be the main item on the menu. The macroeconomic definition of a recession is a contraction in GDP for two consecutive quarters. Taking a look at the actual dollar amount of GDP we are still growing:

So what is all the clamoring about? Well the data is actually a lagging indicator since it takes time and 3 months worth of data to make a quarter but the trend is clear that 2007 had a slow year. It is quite possible that we are already in one quarter of declining GDP. GDP stands for gross domestic product and is a way of measuring a country’s productivity. Basically the formula is as follows:

GDP = consumption + investment + (government spending) + (exports − imports)

Now you know why the decline in retail sales was watched over so closely. Consumption is roughly 70 percent of the US economy so any slight decrease in this area is disastrous in the GDP equation. Also, investment declines are also hurting the country as more and more businesses tighten their belts. You are also aware that we have a trade deficit which exemplifies are uncanny ability to import more that we export. This all combines for the prospect of a very deep recession. Most serious economist already know we are going to head into a recession but the only question is to what severity will it be?

Investing During Recessionary Times

Take a look at the below chart. The gray areas highlight past recessions:

The last recession hit us in 2001 after the tech bubble burst and the attacks of 9/11. It was a double whammy that knocked this economy on its back but keep in mind we were already heading down this path. The chart above shows the amount of disposable household income that goes to servicing debt. This is a crucial chart because it shows how Americans are now becoming more and more heavily pressured by servicing their current debt out of income that would go into consumption or investment (refer back to the GDP chart above). $1 going to pay your credit card debt is $1 that you don’t spend on a widget.

These are important factors to note when planning on how to invest. We are seeing interesting things occur. Take a look at the price of oil chart:

Oil has skyrocketed during this decade and this is important because it increases the cost of energy and many Americans in metro areas are dependent on energy for household needs and also automotive needs. With incomes lagging inflation and energy outpacing inflation the bottom line is households have switched to deficit spending in order to maintain their current lifestyle. Given the massive growth of China and India who are now increasingly hungry for oil it is very possible that oil will not come down anytime soon. No longer are we the only one’s needing oil on a mass scale. Short of the government investing large amounts of money (ala NASA) into energy independence we can expect energy costs to consistently go up. Invest accordingly here.

While certain areas of the economy are seeing radical price jumps we are also seeing depreciation in certain asset classes. Housing for example is trending lower across the USA and in large amounts in Florida, Virginia, Ohio, and California. I think many people get confused with inflation and get caught up in the semantics. The official definition of inflation is an increase in the money supply. Take a look at the below chart:

If we are to look at the M1 money stock chart it would seem that this area hasn’t grown that significantly:

So if we are to adhere to the hard definition that inflation is the growth of the money supply we can say that there is no inflation. But this is not the case and is evident even in under reporters of inflation such as the CPI. If we are to look at the real growth of the monetary system we need to look at M3:

M3 which includes M1 + M2 and repurchase agreements is the place where we have seen explosive growth. This is why we have the enormous credit bubble that we are currently living in. You can almost track and pinpoint the exact moment Alan Greenspan dropped rates to 1 percent and essentially killed the US dollar and setup the US economy for the current credit bubble.

Ben Bernanke has made if very clear that he is going to chop rates even further which bodes well for: commodities, foreign currencies, and paying off debt! Believe it or not paying off debt in a deflationary environment is actually a wise investment move. It is always a wise move but when prices are declining it is important to pay off debt with current dollars since today’s dollar won’t have the same value tomorrow while your debt remains pegged. Case and point is people underwater in their mortgage. You buy a home for $500,000 that is now valued at $400,000. If your income drops from $75,000 to $70,000 because the impact of declining purchasing power, that $500,000 gets more and more expensive. Yet if we have massive wage inflation (do you see this happening?) then that $500,000 won’t look so bad if your income jumps to $200,000 and your home is now valued at $700,000.

It is important to understand the entire scope of the economy especially in a week were most major markets such as the DOW, NASDAQ, and S&P were off by approximately 5 percent. Where are you investing in 2008?

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Much has been argued about the housing and subprime crisis. It would seem from all the media exposure that the housing collapse came on the heels of some unexpected event. It was not unexpected and many people saw this coming. I’ve learned many things from observing the current market forces at work and that is very few people really understand the concept of living within their means. With access to easy credit and a nonchalant attitude about the future, many people simply mortgaged away their future for instant gratification. All of sudden we start hearing echoes of a full on bailout of the housing market. In fact, we are now hearing calls for across the board rate freezes – flipper and speculator alike. Instead of going after bad behavior, we are rewarding people that took on too much risk. If we are to let the marketplace work itself out, we are already seeing countless unscrupulous lenders going out of business. These people were making inordinate amounts of money by putting people into financially dangerous products. It was a horribly broken model. There is plenty of blame to go around and we will have plenty of time to assign it. The major issue I have with this is what about people that actually had some financial discipline and didn’t play this housing bubble game? Should they be responsible for the actions of a market they didn’t benefit from? Much has been said about the BofA / Countrywide buyout deal. In fact, there has been speculation that BofA bought out Countrywide knowing that they would be able to write off many of their losses. BofA is a very profitable company so having these write offs is simply a creative way to avoid paying taxes on their revenue. Not exactly the definition of a bailout but a clever way to avoid paying taxes; something that is not available to the general public.

These things are rather disturbing and not much can be done considering the magnitude of the housing mess. Take a look at this chart that has been floating around the internet regarding the amount of rate resets we will face in the upcoming years:

A couple of things you’ll notice with the chart. The first thing you’ll notice is that we are in the middle of the worst of the mortgage crisis. 2008 will have a much larger number of resets than 2007 and this will be magnified given that housing is already down. It is also the case that now delinquencies for so-called prime borrowers are now increasing only highlighting my initial premises that all people, not only those labeled subprime have lived way beyond their means.

Don’t get me wrong, housing is one of the best investments you can make over your lifetime. That is if you buy at the right price with conventional financing. I know that may sound simplistic and overly conservative but given that nearly 70 percent of Americans own their home and most of their networth is stored in this singular vehicle, it is important to not rely on only one asset and diversify. Since many Americans are still not diversified in their investments we will see the wealth effect retrench in the next few years as housing and the credit unwinding take their toll on the American consumer.

What can you do if you are looking at buying a house? Should you even consider buying a home in today’s market? This answer may surprise a lot of people but the answer is maybe. Buying a home is a simple proposition based on these few principles:

1. Do you have enough income?

2. What are local lease rates?

3. How is the local economy?

4. Are you willing to stay in the property for a few years?

Let us walk through each one and go a little further into detail why these four areas will tell you whether a home is a good deal or not regardless of all the fireworks or gloom surrounding the housing market.

#1 – Income is such an absolute cornerstone of buying a home that these stated income and no documentation loans simply baffle me. How people were able to get $500,000 loans without any documentation is criminal. But that is an entirely different story. Conventional wisdom has it that you shouldn’t spend more than one-third of your gross household income on housing. So for example, say your household brings in $75,000 per year. Your housing payment should not go beyond $2,083. And this is your combined housing payment including principal, interest, taxes, and insurance. This translates to a home valued at $250,000 or so, a price tag much higher than the national median home price. But you say you live in an expensive metro area? Then you must have an income to meet your targeted price. As many areas such as California and Florida are now realizing housing prices do not always go up.

#2 – This leads us into our next issue, local rent rates. It is not a crime to rent. In fact, in many expensive metro areas renters out number owners. You really need to ask yourself what is the reason for buying a home. If you are looking to flip the home in a few months you will be in for the shock of your life in the next few years. This housing market is in for a major correction. Looking at local rent rates also gives you a safety net and idea of what your home would fetch should you need to rent it in the future. Should money really become a pinch, you can always rent your home and move to a much more downsized place. These are options that people are realizing are important now in buying a home.

#3 – This is such a key factor. With the ease of access looking up data on cities and employment information, there is no reason for you not to know an area. It is important to see vacancy rates, foreclosure rates, is the economy diverse, is population growing, and other key factors that will determine how healthy the economy is poised to grow. If you look at Detroit you will see that the economy is having a harder time than say in San Francisco. These are important considerations in factoring a price of a home.

#4 – The last point is probably the biggest mental shift and the most altering for many people. There was a time when people stayed put in their homes. It would seem that time had come and gone in the 2000s. Given the uncertainty of the current housing market, it may very well be that even taking the above measures, you can still buy a home that may depreciate in the next few years. Can you stay put for sometime? Is this something you can support? If the answer is no you may be better off leasing and waiting till the market recovers.

Finally, buy a home you afford and do it with conventional financing and a down payment. It is amazing how many people seem resistant to this idea but in all other decades, this is essentially how buying a home was done. It was a right of passage that you earned and wasn’t handed to you on a zero down mortgage platter. Given the current, atmosphere it looks like many Americans are going to be forced to live within their means.

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