Merk Market Outlook:
US Housing Sector: Micro Foundation, Macro Realities

By Joseph Brusuelas (Chief Economist)

The mild mid summer bounce in sales activity inside the housing sector has stimulated broad market discussion around whether a bottom is forming in the market. Price declines in some major markets have turned around over the past two months and in other major markets they are falling at a slower pace. Combined with the starts data, which we believe is close to finding a bottom; this is the first glimpse of positive news in the sector for quite some time. Although, these developments provide a potential turning point we believe that conditions for stabilization in the housing sector are not ripe at this time.

The major issue looming over the housing market is the continuing problems at Fannie Mae and Freddie Mac. The twin GSE's guarantee over 70% of all mortgages currently originated in the financial sector and to be blunt, at this time the financial system cannot properly function without them.

We have consistently since the start of the crisis around Fannie and Freddie made known our preference for the orderly privatization of the two government behemoths after the credit crisis abates. But, without the government either providing cash as a backstop to them or nationalization at this point the probability of stabilization of the housing sector in the near term is low.

Second, the inventory levels in stock of new homes and existing homes stands at 10.1 and 11.2 months respectively. While prices have adjusted, it has not been sufficient to begin clearing inventories. To make matters worse, foreclosure rates in the Alt-A and prime categories is beginning to pick up. Our forecast is that home prices in the aggregate will have to fall another 10% to begin to move back toward stable equilibrium levels between 4-6 months.

Moreover, when one looks at the spread between the ten year treasury and the thirty year fixed mortgage rate one notices a 248 basis point gap, which is far between the 170-180 basis point spread typical during the last stable era in the housing market during the late 1990's. With rates actually higher than they were one year ago when the meltdown in the mortgage market began we believe that there is more room to the downside in the housing market ahead.

Perhaps, more interesting is the behavior shift among potential buyers. During the height of the mania the expectations of many homeowners were shaped to believe that 20% returns per annum was the norm. This led to the unsustainable extraction of home equity and is one of the primary reasons so many individual find themselves under water on their mortgages.

Today the pendulum has swung back in the other direction. The mean reversion occurring in the pricing of real estate assets is on its way to overshooting a bit, and now many potential homeowners that remain on the sidelines have expectations of potential losses should they enter the market prematurely.

Housing sales have picked up midyear, as one would normally expect during the summer months. Yet, we think that the market may be making a bit too much out of the slight improvement in the data. The housing market will eventually turn. But that is unlikely to occur in 2008 and we do not expect to observe it until prices fall another ten percent. Until the problems at Fannie and Freddie are resolved and prices adjust further to being clearing the outsized inventory on the books and that on the way due to the coming wave of foreclosures in the Alt-A and prime categories, the discussion regarding a bottom forming in the housing sector is all but prologue.

Joseph Brusuelas
Chief Economist
Merk Investments

Merk Investments LLC is the manager of Merk Mutual Funds, including the Merk Asian Currency Fund and the Merk Hard Currency Fund. The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advise nor a solicitation or an offer to buy or sell any products or services. Foreside Fund Services, LLC, distributor.