Can you feel the recession coming on?

Together with a dismal housing report came further news that the Federal Reserve's study of household wealth saw American households becoming poorer in the final quarter of 2007, for the first time since the 2002 bear market.

Now, household wealth recovered from that first bear market, in part because of strong gains in housing and then a recovery of stock prices from post-bubble lows. But this report shows that American households are suffering from declines in both stocks and real estate.

Further declines in real estate are a certainty. I have recently read an article which studied the impact of a decline in real estate values on foreclosure rates It noted that the declines in real estate in the most hard hit markets of the 1988-1991 downturn took years to recover. In fact, foreclosures did not return to pre-crash levels until 1995 or so, nearly 10 years after the boom ended. This bust will likely be no different. If it is, it will be in the magnitude of the decline and potentially the length of it.

I also expect equity prices to stagnate and even fall, especially if inflation expectations continue to be raised. This is because of the impact that inflation has in the perceived earning power of assets. Basically, a higher inflation rate reduces the present value of an investment by reducing the present value of the first cash flows. This is true even when higher inflation leads to higher nominal earnings growth. I will save a more detailed explanation for another post.

The result of the twin fall is a negative wealth effect. Falling value of leveraged assets will lead to a desire to deleverage or to sell. The first will lead to less borrowing and less activity. At a minimum the opportunity to use home equity to consume or "reinvest" in the property itself (remodelling, new furniture, etc). The consumer-led recession, which everyone had been looking for between 2002-2004 will finally be upon us. When that happens, unemployment will begin rising which will then make it all the more difficult to meet high payments.

The same report showed that real estate in America is the most highly leveraged it has been since the end of WWII. (It is not clear if it was higher in 1945 or if there was simply no data).

This is definately a buyers market, but if you are looking to purchase cash flow real estate, prices may yet have to fall in many areas to ensure that an investor can maintain positive cash flow and charge reasonable rents.