August 2006

The Landing Pad

The Landing Pad…As you most likely know, or better know, housing is a classic leading economic indicator in terms of forward directional trajectory of domestic GDP.  In the past, we’ve shown you the very strong historical correlation between the NAHB (Natl. Assoc. of Home Builders) housing survey and the year over year rate of change in real US GDP.  There’s no mistaking the relationship between housing and the economy.  And at the moment, the NAHB survey indicator is pointing directly to a slowing of the macro US economy to come.  And very importantly, it’s not just the builders who are somber, but their customers are also none too confident.  Below is the University of Michigan survey component regarding consumer sentiment toward real estate.  For effect we have overlaid the year over year change in US payroll employment.  Now do you see why housing is so important a leading indicator?  Of course you do.
        

But as we step back a bit and ponder longer term risk in both the real economy and in financial asset prices that represent the real economy, a question of importance is the ultimate magnitude of the “landing”, so to speak, for the greater residential real estate cycle.  Will we achieve the proverbial soft landing the Fed must surely be hoping for, or will it be a dreaded hard landing?  Without sounding melodramatic, the correct answer to this question is of very meaningful importance if you ask us.  Maybe really of primary importance over the next year or so.  For at this point, what happens to housing ahead involves not only the domestic US economy, but also quite crucially the US credit cycle.  As housing “lands”, per se, so lands the broader US economy?  Let’s put it this way, we think it’s a very good bet.

For now, the ultimate character of a housing cycle soft or hard landing is unknown.  Since housing cycles play out over a period of years, as opposed to months or quarters, it’s still probably a while to come until we can offer up an intelligent answer as to the magnitude or depth of the real estate cycle endpoint or trough.  So what do we do in the meantime?  Of course, we watch and listen.  We watch the numbers that characterize the fundamentals of the industry and “listen” to what the financial markets are predicting vis-à-vis financial asset price movements.  We thought we’d have a look at a few of the items we’re watching in an attempt to formulate some type of objective outlook moving forward.  Let’s start with a look at the DJ Home Construction Index.  This relatively broad index was very close to a ten bagger between early 2000 and the summer of last year.  In our minds, it’s literally the picture that symbolizes the systemic liquidity bubble baton handoff from stocks to residential real estate at the dawn of the current decade.  At recent levels, this index is down over 45% in just about 12 months.  This type of price action suggests a good bit of sector distress to us, but so far we have not seen the real US housing sector or industry completely fall apart.  Remember, in the wonderful world of theoretical efficient market theory, financial asset prices lead real world outcomes.  So for now, this index is telling us that the coast is certainly far from clear when it comes to the real world of domestic residential real estate.  
      

As you can see, for now the index has drifted below its 200 week moving average.  As a quick digression, the 200-week moving average is a very generic target one can use if one believes a market, an asset class, or a stock has entered a bear environment of substance.  Is it a picture perfect pinpoint level at which cyclical bear interludes terminate?  No, it’s a generic directional level more than anything else.  But for now, this index literally spent four weeks dancing directly around the 200 week MA before declining to the downside.  What we’re getting at here is that if the real world of US housing is to experience a soft landing, per se, we’d absolutely expect the housing stocks as represented by a broad index such as this to begin to bounce at some point probably in the not to distant future.  While the stocks that make up this index decide in which direction they’ll choose to travel next, the index itself is very oversold technically based on the weekly RSI and stochastic indicators.  In fact, the weekly RSI has never been as oversold in the entire, admittedly short term, history of this index as has been the case recently.  You’ll also notice the head and shoulders formation we’ve drawn in the chart.  If indeed this is a major top with meaningful further downside to come, any rallies or bounces in the index should be contained at the neckline approximating the 800 level.  Of course from here that would be one heck of a bounce.  From a risk management standpoint, for anyone short these issues, a potential northerly price departure from the 200-week MA should be watched closely.

Conversely, a sustained break in this index below its 200 week MA would suggest the probability of a hard landing in the real world of residential real estate is increasing.  We’ve drawn in black the technical support levels that lie below the current price.  If indeed the head and shoulders is not to be violated, it’s a good bet that this index will see 400 or something quite close before it’s all over.

Let’s head out to the real world, Okay?  Another indicator of importance in our eyes is the new purchase mortgage application index brought to us by the wonderful folks at the Mortgage Bankers Association.  It’s clear that the mortgage purchase index is well off of the highs of early last year, indicating that residential real estate activity has surely slowed.  No massive surprise by any means.  But what we think is important is the fact that this index has been stabilizing within a relatively tight range since mid-February of this year.  As you know, we’re in the heart of what should be seasonal strength for housing sales right now.  Looking ahead, we believe a key in trying to assess the soft versus hard landing scenario is whether the current stability, so to speak, in the level of mortgage purchase applications holds.  If we can hold to possibly work higher from here, a dreamed of soft landing may indeed be the outcome, at least for a while.  If the purchase apps index breaks down from the currently very well defined bottoming level, the odds of a hard landing increase.  Simple enough?  Soon enough we leave the prime time residential real estate transaction season.  Will current levels continue to hold?
            

As a bit of an aside, although the housing industry stocks have absolutely taken it on the chin lately, and the mortgage purchase apps are in a clear downtrend, the stocks of companies that finance residential real estate look nothing like their housing industry counterparts as you'll see below.  Why haven't these stocks fallen as has real world real estate activity and the stocks of the homebuilders, etc.?  It's simple.  Remember, as we've told you on many occasions now, the financial economy IS the real economy in the US.  The fact that these stocks have not cratered is simply testimony to the fact that market participants are fully aware of this concept.  At all costs, the Fed will protect the financial economy.  Isn't that really the overriding implicit bet in the broader financial markets these days?  (Answer: Of course it is.)  Moreover, in all likelihood, another set of banking industry executive brain surgeons may indeed take one or all of the folks you see below out in M&A deals.  Wachovia was the first to jump into the real estate finance game after the cycle of a lifetime has already been completed with the Golden West merger.  Who's next?  As you can see below, the stocks are waiting to find out.  Yes, even highly risky sub prime lender New Century seems to implicitly be anticipating a bid.  Oh well, banks and other large financial institutions seem to be doing what they do best in terms of market timing - buying exactly at the top of each cycle.  As you know, the multiplicity of brokerage firm buyouts by the banks in the late 1990's and early in this decade worked out so well that the mortgage lenders must be next, right?  
      

Very quickly an update on refi experience.  Important not just from the standpoint of attempting to characterize the ultimate depth of the current housing cycle, but possibly much more meaningful, the character of a key piece of the macro US credit cycle.  So far, 2006 has seen the worst refi unit volume activity in a half-decade at least.  And this is occurring while $1.2-1.5 trillion in ARM debt is ready to reset over the next twelve to eighteen months.  A break below the 1200 level from here would suggest the housing cycle is taking a turn for the worse and the chances of a hard landing grow.  
        

We have just a few last historical perspectives that we believe are important in terms of trying to assess the forward question of whether residential real estate experiences a soft or hard landing as the total cycle plays itself out.  Unfortunately neither of these will give us any kind of heads up tip off as to the character of the housing cycle path to come.  They are more perspective on the magnitude of the cycle that has already played out. They are found in the GDP report, which is necessarily lagging data.  But important in that they “show” us that the most recent residential real estate cycle is something completely different than anything experienced over the last half century at least.  So as we watch the housing stocks and related indices ahead, the mortgage purchase data, as well as housing starts, permits data, etc., we believe these views of life help us frame the perspective of the cycle we have been living through up to this point.

As we look back over historical cycles of residential real estate investment as a percentage of GDP, we have to ask ourselves, does a minor soft landing follow the most extended US residential real estate investment cycle on record?
        

It sure seems improbable, but in today’s liquidity/credit driven world, anything can happen.  Although we will not drag you through another series of charts, and although the relationship of residential real estate to US GDP sits at a half century high as of 1Q of this year, the year over year rate of change in nominal dollar residential investment peaked some time ago.  Moreover, NEVER has the rate of change in year over year nominal dollar residential fixed investment not gone into negative territory during or very near a US recession until the most recent experience in 2001.  In other words, the current real estate cycle has broken all historical relationships set down over the last sixty years at least.  And the flip side of this record-breaking cycle is a simple non-descript soft landing and subsequent reacceleration upward?  Hmmm, we'll see.

Although it seems to receive very little comment, should we not be mindful of demographics?  In the chart below we’re looking at residential real estate fixed investment and personal consumption expenditures as a percentage of GDP, again over close to the last 60 years.  It seems pretty darn clear to us that the combo of real estate investment (actually consumption from the point of view of households) and consumer spending (PCE) as a percentage of US GDP really began to take off as the baby boom generation came of age, coinciding with the explosion in the financial services driven economy we have come to know and love today.  If indeed the economy is to be influenced by the baby boom generation as we move forward, we need to ask ourselves a few questions.  Just how many more homes do the boomers need to purchase, especially as they go into their theoretical retirement years?  As the baby boom generation ages, we have to believe that the relationship you see below begins to roll over.  Regardless of what’s to come, this is an important picture of the cycle we have already lived through up to this point.  Again, ask yourself, do we simply experience a brief slowdown and then reaccelerate to all new highs ahead?
       

Set against the perspective of the charts above that tell us just how extraordinary the current cycle has already been, we'll leave you with one last question to ponder as we move forward.  Will it just be the level of interest rate movements ahead that will be the primary determinant of how residential real estate influences the US economy?  Up to this point, cost of and ease of access to credit has had just about everything to do with the current real estate cycle.  In other words, will interest rates and residential real estate activity decouple ahead post what has been the residential real estate cycle of a lifetime?  The following will give you a feel for just how closely linked interest rate levels have been to housing stocks and housing activity over the past decade and one half.  As you probably know, DR Horton is the largest homebuilder in the US.  (Notice our favorite LT technical indicators - 21 week RSI in addition to 17 and 43 week EMA relationship - are very negative here.)   
         

Residential real estate affordability depends on two key components - cost of capital and price.  As of the most recent readings (June of this year), the housing affordability composite index rests at a low not seen since mid-1989.  The National Association of Realtors also breaks down affordability between fixed and ARM buyers.  The ARM affordability component of the composite fell to a low not seen for 20 years.  We have the very strong feeling that looking ahead, the character of residential real estate is not going to be primarily dependent on cost of capital, but perhaps more driven by price sensitivity than at any time in decades given the leverage already built up at the household level.  As we said, real estate cycles are long dated by nature.  Even today, mortgage interest rates are well below anything seen prior to 2001 dating back three decades.  There's no question in our minds that price remains today a major affordability index depressant in the numbers we just quoted you from the NAR.  If indeed price and rates need realignment prior to strength returning to affordability indices, does it really sound like an ever so soft landing for residential real estate lies directly ahead?   

One last outstanding issue of importance is the OCC mortgage lending guidelines to come.  You may remember that very early this year, the OCC (Office of the Comptroller of the Currency - the banking system regulator) set forth proposed guidelines that essentially mandate that banks knock off no-doc, negative am, option ARM, etc. lending.  Well, it has been one of the longest "comment periods" we've ever seen for this type of regulatory guideline enactment.  But, as of now, these guidelines are set to take effect by the end of summer.  The only loud vocal opposition has come from the NAR (Natl. Assoc. of Realtors).  We're certain the guidelines will be enacted as almost completely originally handed down due to the fact that neither Congress nor the Senate even made a peep about them.  So, there's going to be additional mortgage credit cycle pressure yet to come.  We have not even experienced the fallout effects of this yet.  And it's clear that both consumer and industry sentiment is literally plummeting prior to this .  Will tightening the mortgage credit tourniquet improve consumer sentiment towards housing or make it worse?  Go ahead and take a wild guess.  Lastly, it's only serendipity that so much ARM debt is set to reprice at the exact time banks are being implicitly mandated to stop risky mortgage lending, as they have enjoyed for so long now.  Oh those fat sub prime margins, right?  We're gonna miss ya.

You already know how we feel about the current housing cycle in terms of its importance to the economy and our investment activities.  We’ll be watching these and many more data points very closely as we move forward.  Again, without sounding over the top, the question of a soft or hard landing in US residential real estate looms very large in our thoughts.  The ultimate answer will clearly reverberate throughout the real economy and US, as well as global, financial markets for a time.  We believe the soft or hard landing in housing to come will also correctly point us in the direction of outcome for the macro US economy.  Will the housing cycle airplane descend toward the economic runway, but reaccelerate skyward prior to its wheels actually touching the unforgiving asphalt of the landing strip?  If so, equities that represent the sector are going to need to find a happy bottom in the not too distant future.  They are going to soon need to "show us" that a soft landing is indeed a possibility, something that has not happened up to this point.  Or will the in flight housing cycle hit the tarmac in a slow motion burst of twisted metal and amid screams of mayday while unable to properly engage its supposed landing gear?  If indeed a hard landing lies ahead for this industry and nouveau asset class, following the charts will be an important exercise in terms of revealing the ultimate flight path for both the industry and US economy.  Quite simply, either the stocks bottom soon, or they will be pointing directly to the fact that the real world housing cycle won't, and by default prospects for the broader US economy, which has been so dependent on household asset inflation for so long, dim.

For now, most anecdotes from the housing industry front point directly to a hard landing.  Single family housing permits are down close to 25% from the top.  The University of Michigan housing sentiment number is back to recessionary levels seen a decade and one half ago.  Existing home prices just fell the greatest amount in two decades on a month over month basis.  The NAHB (Natl. Association of Home Builders) housing index has experienced its greatest nine month drop on record and now sits at a level likewise seen 15 years ago.  And if that's not enough to get your attention, we'll leave you with a final set of current "pictures" below that characterize residential real estate inventories as they now stand as per the latest data.

Head'em Up, Move'em Out...Although the large homebuilders have been reporting new orders that have fallen drastically year over year, the homebuilders, as is the case every cycle, find themselves in a bit of a predicament at this particular juncture.  To cut to the bottom line, they cannot stop building on a dime.  They have so much money invested in each property (entitlement, permit, infrastructure costs, to say nothing of the structure itself) that they can't simply walk away without "stranding" massive amounts of capital.  Not an option.  They need to finish what they have started and blow out the inventory, which now continues to grow by the day.  For now, this is what we are looking at in terms of units still under construction.  See what we mean?  This does not turn down in an instant.  The builders still have a whole lot of "movin'em out" still to do.  We simply can't see how the most extended cycle in history resolves itself without further price pain given the level of current units still under construction in what is a softening transaction environment.
          

Two final charts.  Probably the two most important variables when it comes to equities are price and volume.  That's what makes the world go around.  To be honest, maybe these are the two most important variables that drive any asset class price cycle.  Well, what lies below are two little pictures of price and volume in the wonderful asset class called residential real estate.  In the first chart we're looking at the number of US homes for sale multiplied by the median US home price as of now.  Without sounding melodramatic, price and volume is telling us one large and very important story here.  We've never seen anything like this.
       

Lastly, same data as above, but this time around it's average price.  Same conceptual issue.  To put it tactfully, we're off the charts here.
         

Can this current dollar volume "inventory" situation in residential real estate resolve itself without further ruffling a few price feathers?  Although the final hard versus soft landing verdict on housing, and by extension the US economy, remains to be delivered, storm clouds have clearly gathered and continue to grow just a bit darker by the day.  If we were you, we'd take a few steps back from the proverbial housing cycle landing pad...just in case.  We're not so sure we want to be too close to this thing when it lands.