Real estate hurts San Diego's economy

San Diego — As the second month of 2007 moves along, Wall Street and Main Street are still swashbuckling, but the San Diego economy is noticeably buckling. San Diego stocks? They are historically so speculative and volatile that they could swagger or stagger this year -- one reason why, in general, they are best left to the insiders who get their shares for pennies and don't have to worry about the market's vagaries.

The U.S. economy grew by 3.2 percent last year, and economists look for 2.5 percent this year. But that's based on several rosy expectations: that the housing slump is ending, that the Federal Reserve will lower interest rates this year, and that the phenomenon of short-term interest rates being higher than long-term rates (called an inverted yield curve) does not portend a recession, as it does 80 percent of the time. In short, most forecasters expect a "Goldilocks: not too hot, not too cold" economy, which is perfect for Wall Street but not Main Street.

Believing that all these things will happen requires blind faith. The nation has a negative savings rate. Consumers are tapped out. So are governments at every level. While housing is only 5 percent of the U.S. economy, it has provided 75 percent of the job growth in the past four years. Also, as housing prices went up, consumers borrowed money on those higher values. They spent 40 percent of that and spent 28 percent of the capital gains on homes they sold, according to economist Allen Sinai. If housing boosted jobs and consumer spending so much on the way up, it's probably going to hurt on the way down.

Says Wall Street powerhouse Merrill Lynch: "This is the most overowned, overleveraged, and oversupplied housing market the U.S. has ever known." Them's frightenin' words from a brokerage house that prospers when the economy does well and stocks go up.

Don't convey such news to most of Wall Street; it is only listening to Little Mary Sunshine. Stocks rose about 14 percent last year, greatly because of $3.8 trillion in deals worldwide. People bought a stock expecting somebody else to buy it at a higher price. That's sometimes called "the Greater Fool Theory." The frantic deal making is continuing this year. Wall Street loves deals because it makes so much money from them, but mergers, acquisitions, buyouts, and stock buybacks are the worst way for stocks to go up. For example, last year's $3.8 trillion in deals whooshed past the previous record year -- in the year 2000, when the three-year bear market, one of history's worst, began.

Bottom line: the U.S. economy, buoyed by such factors as oil dropping below $50 a barrel and lower inflation, might grow by about 2 percent this year, avoiding a recession. Stocks could do half as well as they did in 2006.

San Diegans are accustomed to seeing their economy outperform the economies of the United States and California. The San Diego Regional Chamber of Commerce just can't get out of this joyful rut: it predicts that San Diego, while slowing, will do better than the state and nation this year. Nonetheless, only 16,000 jobs will be added; there will be only 25,000 new residents, the slowest population growth in more than a decade, predicts the chamber.

But that's still too rosy, for one major reason: real estate. Even the optimists who believe that the U.S. housing slump is ending do not say that the worst is over for the once-sizzling markets on the West and East coasts. And San Diego's housing market sizzled more than almost all others. In 2000, the median price of a San Diego County home was around $230,000. That shot up to $518,000 in the fall of 2005 and has now dropped 7 percent. Sales were off 25 percent last year. With the inventory of unsold homes up sharply, San Diego has morphed from a crazy seller's market to a savvy buyer's market. This year, sellers will hold on longer, hoping for the market to stabilize; buyers will sit, expecting prices to go down further. The buyers will be right. The decline will hurt home builders. Peter Reeb of Reeb Development Consulting predicts that new home prices early this year will be down more than 12 percent from early last year.

During the housing-boom years, people took on exotic mortgages, betting that their incomes and their home values would continue rising. The latter is already deflating. Someone with an interest-only loan (paying only interest for five to ten years) is betting on rising home prices. Good-bye. Those with option adjustable-rate mortgages (families decide how much they want to pay each month) will likely get in trouble, because the balance of the loan keeps rising. It's called "negative amortization." It's poison.

In recent years, more than 50 percent of San Diego home buyers had some kind of exotic mortgage -- a higher percentage than in other cities. Ouch. San Diegans' incomes are only about 15 percent higher than the national average, but the cost of living is 50 percent higher. Double ouch.

Perhaps as many as 12 percent of San Diego jobs are related to real estate -- sales, construction, appraising, furniture stores, etc. That will come down. Industries that bring in money from the outside are weakening. Biotech jobs have dropped 9 percent in the past five years; computer- and electronic-manufacturing employment is down 20 percent and telecom down 3.5. Tourism jobs are up 17 percent, but wages are low. Much of the rest of San Diego employment (services, retail, wholesale, and the like) depends on population growth, and that appears to be in the past.

Financial counselors often advise investors to stay close to home -- buy stocks in local companies that can be monitored closely. Don't listen. Generally, San Diego stocks are for crapshooters. They are tech, telecom, and biotech stocks that tend to be extremely volatile. They enjoy great hype, but few turn out to be thriving companies. San Diego has 500 biotechs, but only a handful have been financially successful -- that is, racking up steady profits for a reasonable period from a government-approved product.

Consider, for example, the ten local stocks that had the biggest gains last year. In second place was biotech Illumina, rising 178.8 percent to $39.31. But it had hit $51.63 in 2000, the year it went public. In third place was biotech Sequenom, which rose 129.4 percent to $4.68. But it had soared to $573.75 in 2000, its first year, and traded at $65 and $32 in each of the next two years. In fourth place last year was Diversa, rising 126.7 percent to $10.88. But it had zoomed 212 percent to $75 on its first day of trading in 2000, continued up to $169.19, and changed hands above $10.88 much of the time until 2005. In fifth place was retailer PriceSmart, which rose 114.2 percent to $17.91. But it had hit highs above $40 from 1999 through 2002. In sixth place was biotech Isis Pharmaceuticals, rising 112.2 percent to $11.12. But from 1996 through 2002, Isis generally sported yearly highs above $20 and almost hit $40 in 2000.

In ninth place was telecom Leap Wireless International. It rose 57 percent to $59.47. But Leap sold at $94 in 1999 and $110.50 the next year. Then it plunged to zero in 2003 and 2004 as it went through bankruptcy reorganization, shedding $2 billion in debt. Now it is riding tall in the saddle again. Ride these wild horses at your own risk.

If you own your home free and clear or have a conventional mortgage on a residence you plan to stay in, you may dodge San Diego's 2007 woes, and you probably will be able to buy some goods at discount prices. If home values get hit really hard, you might even speculate in the housing market. If the home bloodbath is severe enough, good population growth may resume, assuming there are jobs. But at 3.1 million, isn't the population high enough already?