Most of the reporting on U.S. housing prices has been through the rear view mirror. Let’s take a forward look through the eyes of futures speculators at the Chicago Mercantile Exchange (CME) with the Composite U.S. Housing Index.

We don’t know the profile of people speculating on housing futures, but we’d bet it’s not the same profile as the typical buyers and sellers of the homes that are the subject of the index. We also don’t know the predictive value of the index. It hasn’t been around long enough as a futures product to be evaluated in that way. Nonetheless, it is interesting to see what the futures market thinks.

Here is a chart of the Monday Oct. 29 closing price for the U.S. Composite Housing Price Index for all open futures contract months through November 2011. It’s not a pretty picture.

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If the futures speculators are correct, we are in for a period of about 3 years of continuing declines in aggregate housing prices.

Translated into a percentage chart, futures predict an approximate 12% drop over the next three years before flattening out.

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We all know that real estate is a local asset with great differences between and within communities. Some communities are still rising rapidly and some are sinking rapidly. However, if the futures speculators are correct, the implications are significant, although not necessarily easy to pin down. All that is relatively certain is that a further 12% drop in aggregate home prices would cause a lot of other dimensions of the financial world to change too.

What might change?

Lower home prices would probably mean fewer houses being put up for sale voluntarily, which would tend to reduce turnover, which in turn would reduce demand for mortgages, which would tend to lower mortgage rates.

At the low end, housing affordability would increase due to the combination of lower prices and lower mortgage rates.

Greater housing affordability may reduce the profitability of rental housing on the margin, perhaps impacting apartment REITS such as Equity Residential (EQR).

Another knock-on effect possibility would be that the large crop of baby-boomers who have begun to retire might stay on the job for a few more years to weather the real estate storm. The concerns and fears that would represent, might show up as more conservative securities investing — perhaps more allocation to bonds (proxy AGG) and less to stock; or more to large-cap U.S. stock (proxy SPY) versus small-cap (proxy IWM) or foreign stocks (proxies EFA and EEM).

Nobody really knows how things like this will play out. There are always surprising twists and turns. The past is no perfect indicator. As one writer pointed out last week, Warren Buffet said something to the effect that if the past could be used to predict the future, the richest people would be librarians.

So, with an awareness of the past, a sense of the present and your own crystal ball about the future, it could be useful to think through whether you believe house prices will fall for the next three years and how that will impact other investment markets.

Richard Shaw
QVM Group LLC

Disclosure: Author does not own any security named in this article.

Currency effects on investments are important and probably not appreciated enough by most investors.

If you have a conviction about the direction of the US Dollar, you can power boost your general equity returns by exposing your portfolio more or less to domestic or foreign stocks. If you don’t have a conviction, you are still likely making a currency bet, when you chose your balance of domestic and foreign stocks or stock funds.

Analyzing the results of a multi-company foreign index from the top down can give a fairly clear view of the effect of currencies on index performance, as the table below shows.

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The 3, 5 10 and 15 year annualized returns of the Russell 1000 (proxy IWB) is shown in US Dollars. The MSCI World ex US (proxy VEU), the MSCI EAFE (proxy EFA), the MSCI Europe (proxy IEV) and the MSCI Japan (proxy EWJ) indices are shown for the same periods in both US Dollar denominated returns and in local currency denominated returns – all but Japan involve multiple currencies weighted according to the weight of each country in the index.

The difference between the US Dollar denominated return and the local currency denominated return measures the effect of currency exchange rate changes from the perspective of US Dollar based investors.

For example, the table shows that the return experienced by US investors who invested in the developed and emerging markets of the world excluding the United States should attribute ¼ to ½ of their return to currency effect – the decline of the US Dollar against those other currencies in this case.

You can also see that the relative strength of the US Dollar depressed the Dollar denominated returns of EAFE investments over 10 and 15 years, and over 3 years for Japan investments.

Let’s flip it around now and see how investors based in other currencies experienced returns investing in the United States, as exemplified by the Russell 1000 (the largest 1,000 U.S. public companies).

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You can see that developed world, non-US Dollar investors did better in the U.S markets over a 10 and 15 year period due to a rising Dollar. They did less well over 3 and 5 years due to a falling Dollar. Only the Japanese, in these examples, have benefited by currency effects during the past 3 years when investing in the U.S. stock market.

On average U.S. investors and foreign investors have done better recently by investing outside of the United States. A significant part of the that benefit comes from growing relative strength of other currencies.

There are products that allow investors to take direct currency exposure such as futures accounts, FX accounts, and a growing number of currency ETFs and ETNs (such as UUP, UDN to bet on the direction of the Dollar against a trade weighted basked of currencies; FXE and ERO to hold the EURO; and FXY and JYN to hold the Japanese Yen), but few investors would commit large allocations to those products. Yet, investors make large currency related allocations, often unknowingly, when they decide how much of their equity portfolio will be in US stocks versus foreign stocks.

You really need to consider the currency issue when you design your portfolio holdings and allocations.

Richard Shaw
QVM Group LLC

Disclosure: Author owns VEU.