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[TTHQ Staff]

BEING STREET SMART
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Sy Harding

DOES ANYONE REALLY CARE ABOUT OIL PRICES? August 19, 2005.

It’s hard to believe that crude oil prices have more than tripled just since early 2002, that gasoline was $1.10 a gallon less than three years ago, and is now approaching $3 a gallon.

But who cares?

Apparently not many. There has certainly been no slowdown in demand at the gasoline pumps, no reluctance to pay the price. Highways are more packed than normal this summer. Boats with ever larger engines are still crowding the waterways. Airlines have tacked fuel surcharges onto ticket prices.

But who cares?

Yet, in previous periods when oil and gasoline prices surged up, consumers cut back on fuel consumption long before prices reached these levels. Home-owners took dramatic steps to offset the rising cost of heating oil, with wood-burning stoves and solar heating panels becoming all the rage. The advice of government agencies and consumer-oriented groups to adjust thermostats, up into the discomfort zone in the summer to conserve air-conditioning energy, and down in the winter to conserve heating fuel (while wearing more layers of clothing indoors), were followed with considerable enthusiasm and determination.

This time around? Ho-hum, energy costs just hit another new record high.

No one even seems to mind that the trend of energy costs is accelerating rather than leveling off. It took three years for oil prices to rise $26 a barrel, from $18 in early 2002, to $44 in June of this year. It has taken just three months for it to rise another $22 a barrel, to this week’s new record high of $66. Forecasts of $80, $90, $100 oil are widespread.

So what gives with the lack of concern this time around? It’s called the ‘wealth effect’.

When the stock market was surging up into its bubble in 1999, no one worried about the worrisome conditions that were building. Federal Reserve Chairman Alan Greenspan called it the “wealth effect”. Why worry about the things that are beyond your control when your mutual fund or stock portfolio is gaining 25% a year?
The stock market is no longer providing any wealth effect. It has been in a narrow trading range for a year and a half now, since just before the Federal Reserve began raising interest rates to cool off the economy, and that situation has even worsened, with both the Dow and Nasdaq down almost 2% so far this year.

So what is keeping investors complacent, and consumers still confidently spending?
Greenspan calls it the new “wealth effect”, not created by a stock market rising 25% a year, but by home-owners seeing the value of their homes gaining 25% a year. Why worry about higher gasoline and energy costs, when you’re ‘making’ 25% a year on the investment in your home?

And the new wealth effect has been a huge support for the economy, not only by fueling the robust real estate sector, but by providing consumers with the confidence to undertake the crucial consumer spending of the last few years.

But you say, a home is not a liquid asset. It can’t be sold as easily as a stock or mutual fund. It does not pay a dividend. How can it fuel consumer spending? Simple enough. Lenders turned people’s homes into piggy banks, by making it easy to repeatedly take the ‘profit’ out of homes by re-financing mortgages.

However, we need to remember how the wealth effect created in 1999 by several years of 25% gains in the stock market, came to an abrupt end when it was discovered that even in an enthusiastic bubble, there is a limit to what people will pay for a stock.

And with home prices having spiked up so much that the ratio of home prices to income is now two to three standard deviations above the norm, many would-be home buyers are now priced out of the market, regardless of how easy lenders have made it to borrow money. The sharp rise in short-term interest rates, after the Fed’s ten rate hikes since June of last year, is even making it more difficult for lenders to use low initial short-term ‘teaser’ rates, to entice buyers into mortgages that many won’t eventually be able to afford when the real rates kick in.

Meanwhile, even as home sales remain strong, cracks are beginning to show in the underpinnings. The number of homes coming on the market to take advantage of the high prices is increasing, and with no increase in would-be buyers they are staying on the market longer before being sold.

As random samplings, the Massachusetts Association of Realtors reported there are 35,800 single family homes on the market now in that state, which is 20% more than a year ago. In Texas, Residential Strategies Inc., a housing analysis firm, says Texas builders now have a two and a half month supply of unsold finished houses on the market, “the most in years”.

Historically, as inventories of unsold homes rise, sellers begin to lower prices in an effort to get their home sold before the competition, and the trend begins to feed on itself.

However, even though a decline in real estate prices is likely, it would not take a decline in prices, or a bursting of the real estate bubble, to end the “wealth effect” euphoria. To simply have their ‘investment’ no longer making gains would be a significant blow to current consumer confidence that it’s okay to continue to borrow, run up credit card debt, and spend.

When (not if) that happens, the tripling of energy costs, and higher interest rates, will no longer seem like a minor nuisance to consumers, and the economy will likely lose its two most important supports, the thriving real estate sector, and consumer spending. The stock market, which anticipates conditions six months out, may already be anticipating that outcome.

Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.