January 2007

Homeland Insecurity?

Homeland Insecurity?...To ourselves, the single most important issue for the real US economy and financial markets in 2007 is the fate of US residential real estate and the credit markets that support this asset class.  Despite all the claims by the Fed that current weakness in housing is "isolated", without sounding too simplistic, we know that historically the character of the housing cycle has indeed had a direct impact on US payroll employment and consumer spending behavior.  In other words, at least according to the message of historical experience, housing is anything but isolated.  It's an integral part of the ongoing rhythm of the real economy.  So as we look into 2007, we suggest that the changing nature of the housing cycle will be very important to real world economic outcomes as well as financial market outcomes.  But at least within the context of the current cycle, we believe it's also very important to keep in mind that the changing character of the housing cycle will impact monetary action in perhaps a very big way.  In fact, we think this has already started in terms of the Fed being incredibly accepting of ongoing systemic liquidity creation, especially since the summer of last year.  Despite the fact that the Fed/Treasury/Administration talks a good game in terms of theoretically being vigilant regarding ongoing inflationary pressures, they are anything but monetary policemen as they are indeed the key provocateurs in monetary expansion (otherwise know as monetary inflation).  And given that less and less current financial liquidity is finding its way into the real estate markets, that brings up the possibility that once again monetary excess will find its expression in the financial markets.  Can we make the case that the worse it gets for the real world housing cycle, the greater the possibility that liquidity excess allowed to be generated as a counterpoint to the deterioration in housing may impact the financial markets?  Moving into 2007, we believe these are the very simple macro dynamics perhaps most important to investment survival.

In the spirit of trying to keep our finger on the reality of the housing cycle and anticipate monetary actions to come, we thought we'd very briefly review current housing cycle dynamics relative to historical experience in an attempt to get a sense for where we are and what may be to come .  For anyone who has tuned into the ongoing infomercial that is CNBC as of late, and actually allowed the volume to be turned up, you already know that the favorite pastime of so many of the current commentators spewing "information" on this media platform has now become calling the bottom for the housing cycle.  Without question, we fully expect this to continue throughout the year to come and perhaps well beyond.  For as you know, we witnessed exactly the same experience six short years ago in yet another asset class when headline and mainstream commentators repeatedly attempted to call the bottom for the tech cycle and its related stocks.  But we all know, or should know, how and when asset class cycles truly bottom, right?  They bottom when no one is any longer calling for the bottom.  They bottom in silence.  In terms of housing?  At least according to the relatively important cacophonous CNBC chorus of the moment, we're not even close to a bottom.   But, as always, that's our opinion.  Let's look at the facts, shall we?

Bottoms Up?…So where do we start?  With starts, of course.  To try to maintain our bearings, we want to have a quick run through the history of residential real estate cycles of the past 45+ years by having a look at housing starts and permits.  We ask you, what could be more fundamental and crucial data points for the industry as a whole?  (Answer:  Not much.)  Okay, this is what we’ve put together.  We’ve gone back and looked at both depth and duration as applied to the history of housing permits and starts data.  We’re documenting duration (monthly) of peak to trough cycles in terms of starts and permits.  And lastly, we’ve calculated percentage declines in starts and permits over all down cycles.  For each we start off with a long term chart followed by a quantitative table that’s essentially documenting what you see in the charts.  First at bat is the historical cycle of housing starts:
          

You already know that in the most recent residential real estate cycle we lived through the longest duration in the up cycle for starts on record.  It’s more than clear above.  It just so happens that the recent peak in housing starts was seen in January of 2006, as you’ll see in the table below.  We’re maybe eleven months into the decline.  What does history tell us to expect?  Just have a look.

The average cyclical peak to trough decline in starts historically spanned a 46-month time frame.  The shortest contraction on record over the past 45 years was twenty-eight months.  Can it really be that the current down cycle is done after only eleven months?  We think not.  Moreover, the average percentage decline in starts from cycle top to bottom historically has been just shy of 62%.  So far our current experience has been 30.0%.  There’s no question that the recent cycle has seen a very steep drop over a compressed period of time, but common sense tells us this is nothing unusual given the prior unprecedented up cycle length.  In the past we’ve pointed out to you the literal unblemished consistency in cycle bottoms at or below 900 thousand in every cycle since 1960.  Do we now really bottom at almost twice that level?  Moreover, IF we again reach historical cycle bottom experience so clearly visible in the chart on starts, we’re set to drop another maybe 45% from here.  Has the market already priced that in?  Again, we think not.  If the bulls are correct and stabilization/bottoming has occurred, as we are increasingly hearing, then this will be the shortest and most shallow down cycle for housing starts on record in a half century at least.  Just ask yourself, set against the context of historical experience, are you willing to bet the bottom in starts has already arrived?  (Hint:  The deck is stacked heavily against you if you called a bottom.  Want to try again?)   

We’ll make this quick.  We’ve gone through the same conceptual process with housing permits as in the case of starts.  As you’ll see in the chart and in the data, the results are strikingly similar to the starts data and historical message.
            

For now, history is very strongly suggesting to us that the bottom calling game in the residential real estate cycle is still in the early innings.  As with most asset cycles, we fully expect the real bottom in residential real estate to come when everyone stops the headline media bottom calling.  Exactly how it played out with tech stocks over the 2000-2002 period.  The pattern of human behavior surrounding cycles of asset class price movements never changes.  As Jesse Livermore once said about the financial markets, “only the wallets do (change)”.   Remember, the real bottom comes when no one is any longer calling for it.  We’ve got a ways to go yet.  But the story clearly does not end with starts and permits by any means.

At least for now, and remember we're currently in the midst of the slow calendar period for real estate sales, inventory remains an issue.  A big issue.  In terms of new homes under construction, isn't it clear that we are simply barely off of major cycle highs at this point?  It sure as heck appears so.  And this is what Bob Toll calls "dancing on the bottom of the cycle"?  With all due respect, we beg to differ.  In our view of life, THE issue for both public and private builders at this point is stranded capital, plain and simple.  It just so happens that our home state of California is a poster child for this issue.  For many a home builder in the wonderful golden state, per lot sunk costs prior to sticking a backhoe in the ground to dig a T-footing foundation can run into six figures without even breathing hard.  Entitlement, permit, environmental, utility hook-up, infrastructure costs, etc. have been and continue to be huge.  Municipalities have clearly partaken in the current real estate cycle largesse in a big way vis-à-vis fees and costs assessed builders.  So when the cycle music stops, many a builder may find itself with huge sunk costs in what are literally buildable lots of the moment, and that's about it.  What do builders faced with significant stranded capital do at the top of a cycle?  Build faster and move the inventory.  It's simply economics 101.  If you saw the recent housing starts report, you know exactly what we're talking about.  Starts up above expectations, but permits clearly down.  In terms of stranded capital in the homebuilding business, it's start'em, build'em and sell'em at this point.  It's no wonder the following chart looks as it does.  Although we're not industry experts by any means, it sure appears to the untrained eye that we are nowhere near "stabilization", let alone any type of definitive bottom.
          

In addition to the current level of new homes under construction, the character of housing inventory is further illuminated by the sheer nominal number of homes for sale in the US, again remembering that the current is the slow period for sales.  Interestingly, but certainly not surprising by any means, is the fact that the percentage of homes put up for sale in 2006 with either expired listings or taken off the market were at a level not seen in many a moon.  Will these folks give selling a second shot in 2007?  If so, it's a pretty darn good bet that we've not yet seen the top for this indicator in the current cycle.  As is clear, current levels of US homes for sale is really light years above prior historical peaks.  And against this context, mainstream commentators are calling for a bottom in housing?  C'mon, do you think we're complete idiots?
                 

As a final corollary to residential housing inventory and just where we are in the current cycle is the following historical view of months supply of houses on the market at current sales rates.  A few comments if you don't mind.  First, looking back over history, we're at a relatively important juncture here.  Every single time over the last forty years at least that months supply of homes for sale has been at eight months or above, we've either been entering or in an official recession.  No exceptions.  We're in the low six month range right now, but it sure seems a good bet this goes higher given the extent and magnitude of the prior up cycle.  For now this remains to be seen.  Moreover, please be aware that quite importantly, cancellations are not counted in this measure.  You already know that it's not uncommon for cancellation rates at the moment among many of the large public homebuilders to run in the 40%+ range.  That's one big number.   

Secondly, at least in terms of historical experience, spikes in this measure have preceded price softness or declines.  After all it's only human nature in action.  The first behavioral stage of every asset class cycle decline is denial.  And the denial of the moment is over price.  Sellers are reluctant to drop prices and buyers reluctant to pay current prices.  The character of this data series moving into 2007 should be quite the "tell" as to how the housing cycle plays out.  

Finally, notice in the chart above that at prior cycle peaks in the number of homes for sale in the mid-1970's, early 1980's and late 1980's, months supply of homes for sale was well above current cycle experience so far.  The explosion in current cycle number of homes for sale suggests months supply at present is nowhere near a peak.  We'll just have to see how it all unfolds.
         

We'll stop here.  As you know, we could continue on for pages with charts and commentary pointing out the very meaningful differences in current cycle dynamics relative to historical cycle bottoms.  The simple message is that unless we are about to very meaningfully depart from what has been very consistent historical experience, the housing cycle isn't even close to a bottom right here.  And yes, these facts certainly will not stop the CNBC carnival barkers from attempting to attract "takers" based on one-off sound bites moving forward.  But in terms of the real world, at the end of 3Q 2006, household real estate holdings totaled just shy of $20.5 trillion.  Household holdings of common stocks in the same period registered $8.3 trillion.  Bottom line?  The housing cycle is the key to the real US economy in 2007 as transmitted through US consumer behavior. So far, US consumers have weathered the increasingly darkening skies for domestic real estate quite well.  As of 3Q 2006, our friends at Freddie Mac tell us that 89% of refis done were cash out refis.  Households clearly continue "to believe".  But cycle dynamics sure seem to suggest that "belief" in residential real estate as an ever producing fountain of wealth creation will be more than tested in 2007.  Can US households and ultimately investors in US financial markets handle the truth?  We're about to find out dead ahead.

Action And Reaction...As is very important to remember at all points in time, what happens in the real economy and what happens in the financial markets, that are ultimately a reflection of economic reality, can be two different things over very short periods of time.  As investors, we need to constantly distinguish between the personal need to be right in terms of fundamental outlook and yet putting into actual practice what it takes to make money.  In the financial markets, as is true in many physical laws of nature, for every action there is a reaction.  And set against the reality of the housing cycle we indeed expect reaction.  

Again, although it's a very simplistic comment, the Fed will not sit still and watch housing deteriorate to any meaningful degree in 2007.  Why?  Because at least historically, the correlation between the US housing cycle and US consumer spending dynamics is about as tight as anything we've ever seen.  You can see it clearly in the relationship between the NAHB housing index (National Association of Homebuilders) and the year over year rate of change in real personal consumption expenditures (consumer spending) below.
                

As has been the case for so long now, liquidity will be the order of the day in terms of counter cyclical artillery to hold back the fallout influence of any further housing cycle deterioration.  As we mentioned, it's already well under way.  The following chart is again the historical months supply of homes for sale now set against the historical movement of the Fed Funds rate.  Highly correlated directionally?  You bet.  
             

But what seems quite the differentiating factor in the current period is that during this cycle housing price acceleration was not choked off in large part by restrictive credit.   Short rates have clearly influenced the cost of adjustable financing, but the cost of conventional financing is up maybe 100 basis points at present from its current cycle lows.  And it's really only in the past month or so that very questionable subprime activities have begun to become problems as witnessed by shifting credit spread activity.  Question.  Is it really a 100 basis point increase in the cost of conventional financing that is responsible for bringing the greatest residential real estate cycle in history to its knees?  We know at this point that current cycle excess has been in both mortgage credit availability and physical supply.  So as the current housing cycle continues to play out, we anticipate the Fed will fight any type of continued deterioration every step of the way, as was exactly the case with the tech/greater equity bust early in this decade.  Given the leverage both in residential real estate and the US economy as a whole, they really have no other alternative at this point except monetary inflation.  Remember, these are not the policemen, but the provocateurs of price inflation.  So from a practical standpoint, we need to monitor Fed artillery supply (monetary/liquidity expansion) as well as direction of rounds being fired (to where does the liquidity flow?).  And this can and will have a direct impact on financial market outcomes.  The more the Fed/Treasury/Administration/Wall Street attempts to fight what we believe will be continued deterioration in the real world of US residential real estate with monetary inflation, the more excess liquidity driven financial speculation may unfold.  This has been our immediate history, so why not our immediate future?

We'll leave you with an excerpt from a recent (November '06) Fortune interview with Treasury Secy. Paulson.  And we'll also leave you with a question to ponder.  Is this personal conjecture on the part of Paulson, or is this simply implicit policy at this point?

Please remember, the reality of the US economy and how that reality is mirrored over the short term in financial markets can be two very different things.  Being right and making money as investors can be two different things.  Especially in today's world of interest rate and credit derivatives mushroom clouds.  We know exactly how the Fed/Treasury/Administration/Wall Street reacted to the tech stock bust.  Should be really expect anything different conceptually in terms of a reaction to a housing downturn?  We think not.  Listen to what Paulson said above.  Listen.  The decline in housing is not going to occur without one big "reaction".  Capiche?

Although we are far from being in possession of a crystal ball, given the immediate US circumstances we have just described, what does this portend thematically looking ahead?  Personally, we expect sector and overall financial market volatility to increase looking forward.  Regardless of the US residential real estate cycle outcomes near term, the clear theme of meaningful long term economic growth in emerging markets (China, India, Brazil, Russia, etc.) remains fully intact.  Any type of meaningful softness in these markets driven by US consumer behavior/credit cycle dynamics over the short term should be seen as long term opportunities.  If the Fed accelerates its monetary reflation efforts from here, non-dollar investment vehicles as well as investments negatively correlated with the US dollar are deserving of consideration.  Global labor arbitrage opportunities remain intact.  Any pressure on US corporate profits will only increase labor arbitrage activities.  Hence, cash rich global blue chips truly focused on enhancing shareholder value (as opposed to simply supporting stock options programs) remain of interest.  Total rate of return, yield tilt, and a defensive sector focus in US markets appears the appropriate stance at this point.  Set against historical context, the length of the current economic expansion and equity market up cycle are long in the tooth.  Finally, and this is always the case, well defined and executed risk management disciplines are paramount.  Long term investment survival is not about hitting home runs.  It's all about consistently not striking out.

We wish you and your families a healthy, peaceful and prosperous New Year ahead.