Listening to NPR and reading the business press commenting on yesterday's Wall Street selloff, I repeatedly see the phrase "look to the fundamentals." This is good advice, but I can't imagine which fundamentals these folks are looking at, since the fundamentals seem to reassure them. When I look at the fundamentals, I see front and center an unprecedented explosion in house prices. From 1953 to 1995 house prices track the overall rate of inflation closely. From 1995 to the present, house prices have risen by 70 percent in real terms. No one has an explanation for this run-up based on the fundamentals of the housing market. (The lack of any significant run-up in rents seems to disqualify any explanation based on conditions of supply and demand in the housing market.) This run-up in house prices has created more than $5 trillion in housing wealth. This has spurred an extraordinary consumption boom, pushing the savings rate into negative territory for the first time since the beggining of the Great Depression. The fundamentals I see are the unraveling of a housing bubble, leading to further declines in the housing sector, and a big hit on consumption, as the fuel of bubble created housing equity disappears. The hope that declining construction and weak consumption would be offset by soaring investment disappeared with yesterday's data showing a sharp drop in durable goods orders. It looks like investment is going the wrong way. Throw in the fact that rising interest rates in Japan may slow the inflow of foreign capital that has kept long-term interest rates so low and productivity growth appears to have slowed sharply (benchmark revisions next week will push reported productivity growth over the last two years downward) and it's pretty hard to find much positive in this picture. So, I agree completely with the analysts urging people to focus on the fundamentals, but I just can't see where they find anything positive , perhaps their own salaries? [addendum -- don't forget price to earnings ratios as one of the fundamentals. The economy may look fantastic, but if the PE is 100, it would be very foolish to hold stock. Current PEs of near 20 against cyclical peak earnings look pretty high.]
--Dean Baker