Housing starts on fire

The residential construction sector is in full-blown recovery mode, with plenty of upside potential left.

December housing starts jumped by 12% from November, exceeding all expectations (954K vs. 890K). Starts rose 37% last year, and they are up by a very impressive 77% in the past two years. Yet despite those impressive gains, starts are only now back up to the level that has marked the low of most of the recessions in the past 50 years. That's how bad the collapse was, but it also points to lots of upside potential—starts could easily double from here over the next few years. Residential construction will be a strong force sustaining overall economic growth for the foreseeable future.

The ongoing recovery in the housing market also provides support for further gains in home builders' stocks, and in many other housing-related industries.

Just in case you haven't been involved in trying to buy a house recently, it's a seller's market. The chart above shows the Radar Logic housing price index for 2011 (orange) and 2012 (white). Housing prices have strong seasonal tendencies, and typically decline from August through January. This year, however, they aren't declining. Prices in mid-November were 9% higher than in mid-November 2011. If my personal experience and that of close friends is any guide, there are bidding wars erupting and houses (especially the more affordable ones) are going for much more than their asking price.

Why Treasury yields are so low

December's Consumer Price Index was unchanged, as expected. It rose 1.74% last year, which, as the chart above shows, is somewhat less than its annualized rate of 2.4% over the past 10 years. Meanwhile, the core CPI rose 1.9% last year. It's hard to find anything out of the ordinary in the inflation stats these days.

What does stand out, however, is the unusually low level of T-bond yields relative to inflation. The chart above is structured to show that 30-yr bond yields over very long periods have averaged about 2.5% more than core inflation. If that long-term average condition were to prevail today, 30-yr T-bond yields would be trading around 4.5%; instead they are 3.0%. Bond yields were arguably fairly valued for much of the decade of the 2000's (as the two lines frequently overlapped). But in the past year or so, bond yields have fallen while inflation has risen, and 30-yr bond yields today are only slightly higher than the average inflation rate over the past decade. Thus, bonds arguably are richly valued today.

It's commonly thought that bond yields are low because the Fed is buying a lot of them in conjunction with its Quantitative Easing program. But the Fed todays owns only $1.7 trillion worth of Treasuries, or 14.4% of all the Treasuries held by the public. The public, in other words, owns $9.9 trillion of Treasuries, which is almost seven times more than the Fed owns. I find it hard to believe that the Fed's ownership of only a fraction of the outstanding Treasuries, and its willingness to buy another small piece over the course of this year, is enough to significantly distort the pricing of all of those securities. Common sense tells us that the price of Treasuries is determined by the public's willingness to hold the outstanding stock of Treasuries, not by anyone's willingness to purchase the new Treasuries sold on the margin.

What is more plausible is that the Fed's repeated promises to keep short-term interest rates low for an extended period, conditioned on the economy remaining relatively weak and with a surfeit of unused capacity, are convincing enough to encourage the market to bid up the price of Treasury notes and bonds beyond a level consistent with the prevailing inflation rate.

It's a readily observable fact that the economy has managed only a tepid recovery from its worst recession in modern memory, and it's clear that the burdens of government—spending, taxation, and regulatory—are greater today than they have ever been. It's not hard, therefore, to conclude that the economy is unlikely to grow by enough in the next few years to cause the Fed to accelerate its timetable for higher interest rates. This, I would argue, coupled with the market's generally high level of risk aversion (which can be found in $1700 gold, negative real yields on TIPS, the relatively low level of equity PEs, the 70% growth in bank savings deposits since late 2008, and the huge outflows from equity mutual funds in recent years), offers a much more robust explanation for why Treasury yields are so low today. The market is scared, and confidence in the economy's ability to generate stronger growth is very weak. The market is thus quite willing to pay a premium for the safety and security of Treasuries.

Low yields on Treasuries are thus an excellent indicator of how bearish the market is, regardless of what the surveys might say.

Manufacturing activity jumps in December

December manufacturing production jumped 0.8%, exceeding expectations of 0.5%, and ending a slump that began last March. Shelve those fears of a developing recession.

Thanks to a 3.3% gain in the past two months, production of business equipment is now at a new all-time high.

Ongoing gains in U.S. industrial and manufacturing production stand in sharp contrast to weakness in the Eurozone (where industrial production fell 3.5% from August through November), and Japan (where industrial production last November was down 9% year to date). Despite all the headwinds at home and abroad, the U.S. economy retains much of its inherent dynamism. I'm reminded once again that it almost never pays to underestimate the ability of the U.S. economy to overcome adversity.