Housing Down, Industry Up

With the economy in retreat, at least in the U.S., Europe and Japan, it's a good time to assess how the current recession will change future behavior. After the short term pain, their will be long term gain for industry in general and for machine builders in particular.

The catalyst for this slowdown was the residential real estate bubble. Favorable demographics and a raft of government incentives fueled an unsustainable rise in real estate prices. Now that the bubble has popped, consumers and investors will behave differently.

Specifically, the U.S. in particular has seen massive overinvestment in residential real estate during this decade. Millions of people chose to invest billions of dollars in housing, and these funds were often diverted from the stock market. Funds diverted from stocks to housing often depress industrial investment, directly affecting machine builders.

New housing construction does have a positive impact on industry and machine builders, but much housing bubble investment was people simply paying more for existing re-sale housing. Inflated prices for new houses also don’t directly translate into more demand for construction materials because much house price inflation was due to run-ups in land value.Because many are now on the hook for huge mortgages, consumer spending is feeling the squeeze. Declining stock prices don’t help either as consumers feel nervous and naturally want to save more and spend less. Lower consumer spending directly impacts industrial concerns like automobile manufacturers and the machine builders that supply them.

But lower housing prices will eventually free up funds for other investments. Every home that is sold has a buyer. Sellers are losing because their houses are worth less, but buyers are winning. Many buyers are moving from rental housing to their own residences and cutting their after-tax monthly payments in the process. This is freeing up money that will either be spent or invested.

If it is spent, it will help consumer spending. This is significant as consumer spending accounts for a large portion of the economy in all developed nations. It’s important to machine builders because it’s hard for a consumer to spend money on goods and not consume a product produced by a machine.If food is bought, a machine was used to process and package it. If a car is bought, machines were used to produce it. If clothing is purchased, machines were used to produce the thread and assemble the garment.

If money saved on cheaper housing is invested, the short term effect on stocks and industrial investment will be limited. Many investors are scared witless and are currently putting all available investment funds into low-yielding safe investments like Treasury bills. But that will eventually change as the general public realizes that this recession will also pass, just like all economic slowdowns. Some people are ahead of the curve right now. 

Warren Buffet is generally recognized as the world’s most astute investor. He is always asked for advice, and his reply is consistent. Invest when others are fearful, and sell when others are greedy.Buffet has committed about $13 billion in high profile investments over the last few months, about $8 billion of it to industry. He put up $4.7 billion for Baltimore-based Constellation Energy, the nation’s largest wholesale power supplier and the owner of Baltimore Gas and Electric. Buffet also bought $3 billion worth of General Electric preferred stock.

This is a ringing vote of confidence for industry from the world’s smartest investor and a great sign of things to come. Buffet habitually gets in near the bottom and sells near the top, and it’s unlikely that this time will be any different. The bursting of the housing bubble will also affect future investments. In the past, investors in residential real estate were eager to buy properties with significant negative cash flows. That is, the cost of buying and maintaining the property was much greater than the rental income.Residential property is now going to be priced in close relation to rental incomes for a long time to come. This will keep housing prices down and free up funds for consumer spending, and for stock market and industrial investment.