For many of you this name may be unfamiliar, but others of you know him as the third richest man in the world behind Bill Gates and Warren Buffett. The reason that I use Mr. Mittal is for a recent real estate purchase he made. The steel baron purchased a 12-bedroom mansion on London's Billionaires row for a whopping 127 million dollars.

Now does Mr. Mittal need a house this big? Of course he doesn't! But he can afford it. Since 2001, people in the United States have been on a real estate purchasing spree. Like Mr. Mittal they have been buying larger houses than they need, and even second homes that they certainly did not need as investments.

The big difference is Lakshmi paid for his residence in cash while the majority of homebuyers did not. My point being, Americans have been living beyond their means for some time since the market downturn in the stock market because of historically low interest rates and soaring property values. They have used the cash from refinancing to pay off credit cards and then they turned around and started the spending spree all over again. Their standard of living was not compromised because many had this new cash register called home equity. This is the reason that the recession-like environment we witnessed in 2002 was so short lived because the consumer helped us to spend our way out of it. 

Some savvy people also began to sell their homes, in very high priced markets such as in California, and move to more affordable markets like Montana. This has pushed up home prices all across the state of Montana. At the same time that people were witnessing their ex-neighbors basking in the glow of "real estate money" from big gains realized by selling their homes, they took a look at their equity portfolio, and what they saw was not pretty.

Their portfolios in 2002 were literally dead; they had watched their stocks do nothing but go down. Their once beloved tech stocks were trading for pennies on the dollar, and some companies run by so called "geniuses" were on the verge of bankruptcy like my all time favorite Enron. So people decided to bite the bullet and sell their under performing equities and move to something tangible-Real Estate-because as I have heard over and over, "They ain't making any more land". This of course put in a bottom on the Dow at 7,197.50, which will probably be the bottom for another 20 years. I personally thank all of the nice people who did this! 

You can see from the insert below, courtesy of the St. Louis Federal Reserve, the constant decline in retail money funds, which is the cash that is sitting in your equity portfolio.

 As you can see people were taking money out of their equity portfolios in mid 2001 and have ceased to stop. Meanwhile, as they continued to take money out of equities, the market bottomed and turned up, where it sits today despite the massive outflows of cash by investors.

Jack and I debated why retail money funds number continued down while the markets continued to strengthen, because people would have had to put money back in their account to buy. Then it occurred to me that people had been taking this money out to purchase real estate. We had a few clients take out money from their money fund to make these purchases and a few other clients who liquidated their entire portfolios to "invest in real estate".

I will now give you a few numbers to chew on courtesy of the National Association of REALTORS. In 2002 the average price of an existing home was $199,200, $215,000 in 2003, $236,600 in 2004, and finally in February of 2005 it was $ 243,000. Now one does not to be a Harvard MBA to figure out that if you bought a house in 2002 and sold now you made a great return. The average existing home price has increased 43,800 dollars or 22%. For a single-family residence prices have moved from $ 201,600 in 2002 to $241,700 in February of 2005. This represents an increase of $ 40,100 or 19.9%. Now for my favorite, which would be, condo prices, which have moved from $180,900 in 2002 to a whopping $ 252,600 in February on 2005. This monumental increase was $71,700 or 39.6%.

Now I don't know about how you feel, but from a spectator on the sidelines these price increases seem monumental to me. These kind of gains were seen in the Japanese real estate housing market during the late 1980's and early 1990's before its real estate market crashed following their stock market bubble.

Now lets move on to the main factor in the real estate game, which is interest rates. As interest rates increase the number of people eligible to purchase a home decreases. As mentioned earlier, interest rates were at 40-year lows, and have begun to tick up. The affect of this can be seen in the Weekly Mortgage Application survey (WMA). On an adjusted basis for the week ending March 18^th it was down 39.3%, in comparison with the same week only one year earlier. You don't have to be rocket scientist to figure out that less mortgage applications means that fewer homes will be purchased. 

Surprisingly at the same time that the mortgage applications were down surprisingly the number of ARM (Adjustable Rate Mortgages) increased to 33.5% of total applications. This is a major red flag! Adjustable rate mortgages are in my opinion a bad idea when done in a rising interest rate environment. They are fine when rates are decreasing, but certainty not in this atmosphere. This tells you that the uninformed real estate speculator is buying at this moment.

Does this remind you of another bubble in which overeager investors were driving up the prices of investment vehicles? Say tech stocks in 2000! The main problem here is on the lower income side. We will just take a look at the state of Montana for our example, which has seen a "white-hot" real estate market in the past few years. According to the U.S. Bureau of Economic Analysis the average per capita income for Montanans was $26,856, ranking it as 45^th in per capita income in the United States. With the average house price in Bozeman, Montana is $250,000 according to 2 knowledgeable local realtors. (I regret I could not find the average house price in the entire state on Montana, but it seems that no one tracks this. Of course there are cheaper markets in Montana than Bozeman, but there are also higher priced areas.) The houses have become too expensive for the average Montanan to afford which will lead to people being priced out of the market.  The concern for this area becomes the number of adjustable rate mortgages, which I believe is a great number of the areas mortgages. I have seen signs that advertised such things as zero down, as well as interest only loans. These are again red flags! High Oil prices will also lead to the downfall of the lower income (ARM) homeowner. The invisible tax of $50 dollars a barrel on crude hurts everyone in the economy. So the average income earner in Montana ($26,856) now has extremely expensive gasoline ($2.10) a gallon for the least expensive last time I checked. This coupled with a rising interest rate environment spells disaster!

Since many were allowed to put very little down on the home, they do not have much equity tied up in it. As rates rise, and they can no longer afford the payments they will simply walk away, and this leaves the Bank with the property. Now what does the bank do? Well, they turn around and sell the property at auction, which if course pushes the price of the home down, and in theory the houses around it.

This is a worst-case scenario, which I believe could happen to what has been a market on fire in Bozeman. As one gentleman exclaimed to me "You always make money in Bozeman real estate" (I wonder if this gentleman had been in Bozeman in the mid to late 1980's when I have been told that you could not give your property away.) We will just have to wait and see.

Let us discuss something that I am far more experienced with which is stocks, and specifically the Homebuilders. Anyone who has purchased a homebuilding stock has made a great return over the last 5 years, and kudos to them. But the glory days for these stocks are nearing an end. I have seen every talking head on CNBC touting these companies, and the CEO's of these companies talking about how this is just a pure supply and demand issue. Apparently these individuals know something that I am unaware of. Is there a boat coming from India with 30 million people clamoring to buy a home in the red hot Las Vegas market, or maybe planes with millions of Chinese who are eager to move to a slower growing economy to buy homes? I just want to know where the buyers are gong to come from? Let us take a look at the valuation of the homebuilders.

Historically the housing stocks trade at a P/E of around 6. You can see current multiples are much higher. Why are they higher, well people are buying into their growth stories. Now the S&P 500 trades at a multiple of around 21.5 times earnings. So these stock are priced about half as much as the S&P 500. The anomaly is that if people believed this "growth story" that these P/E levels would be even higher than they are today, with the exception of Toll Brothers.

In my opinion the smart money does not believe the growth story. If they did, then the multiples would be even higher than they already are. This can be seen in the steel sector where the aforementioned Mr. Mittal's company Mittal Steel is trading at a P/E of 4.27. Now many people will argue that that multiple is cheap, but I do not agree. The stock is up more than 300% in the last year, and I believe that China will be a net exporter of steel in the second half of 2005. I argue again that the smart money does not buy Mittal Steel's P/E (In the short term), and it does not buy the P/E of the homebuilders either. Let us take a look at what these companies would have to earn in order to sport their historic P/E's

These companies may very well earn this much in 2005, but in my opinion I do not believe that this is very probable. The CEOs of the housing firms say that they have large backlogs, and their selling prices are already agreed upon. This is true. The other fact that you will not hear any of these executives discuss is that the majority of them have no commodity hedges. As anyone well knows the prices for gasoline, copper, and lumber have gone through the roof the last year. So while the companies have locked in selling prices, they did not account for the large up swings in their building materials costs. This will hurt margins, and thus earnings. Now let us see what price the companies should be based on an earnings multiple of 6.

The above shows what the stock prices of these companies should be based on a historic P/E for the group of 6. As one can see their stock prices are very over valued compared to what they trade to relative to their historic valuations. In my opinion these stocks look overvalued.

The last section of what has become my manifesto is the simple one, and that is Common Sense!!!  Everywhere I look I see new houses for sale, old houses for sale, brand new commercial spaces for lease, and for sale, and even entire apartment complexes for sale not just in Bozeman alone, but just as much in Houston and numerous other cities across the country.

When talking about topping markets I love to use the famous example of Joseph Kennedy. When Kennedy was a heavyweight on Wall Street he was getting his shoes shined downtown one day. The entire time the shoeshine boy was giving him stock tips, and telling him what he was buying. Kennedy immediately went to Wall Street and sold off every stock in his portfolio. A week later the crash of 1929 began, and Kennedy had managed to sidestep the worst bear market on record. As you can see when the uninformed investor is moving into the market, and the seasoned veteran is exiting the market, this signals a top in whatever market it may be, from stocks, to bonds, to real estate. On this note I have an interesting real life story to share with you. A month or so ago, I talked to an acquaintance who is 25 years old, and just married. They and their spouse had recently purchased their first home, and to my surprise also just purchased a second home, for "rental income". I did not ask, but I am sure that they did not even put 20% down on their first home purchase. Now at the same time CALPERS (California Public Employees Retirement System), and Houston real estate mogul Gerald Hines have been taking profits on certain pieces of commercial property by selling at these high levels. CALPERS alone has sold some 6.5 billion dollars of commercial real estate in the last 3 months. A final story takes place a day or two ago when I was getting lunch at Subway. I was talking with an elderly woman who worked there, and also dabbled in real estate. She told me that she had cashed out her IRA a while back and put it into real estate assets. " I was sick of seeing the account go down every day, and you can always rent out a house," she said. This has been the thinking of millions of people and further solidifies the hypothesis I held that explained the drop in retail money funds, and the escalation of the real estate prices. Now you can use your own judgment here, but it looks to me that the smart money is exiting the market at the top, and the uninformed investor is chasing the allure of red-hot "real estate" money.

Now, I have no real estate training, and have taken only one class at Montana State University that dealt with real estate, so I do not claim to be any kind of expert. However as a value-oriented investor I have developed something of an eye for overpriced and under priced markets. So I do believe that a real estate downturn is real, and is coming very soon. How severe will it be I can only guess! Do I recommend going out and selling your house and hunkering down for the downturn? Of course not! But I would advise against the purchase of second and third homes in the current market environment. I personally will be using technical analysis to determine when to buy long term out of the money puts on certain housing stocks!

Thank you for your time.

Jack