US housing market - still weak

Core logic came out with their house price index with data up to November. The data is repeat sale like the Case-Shiller index so should be reasonably reliable and covers all states so is broader than the Case-Shiller index which I commented on in my previous post.

Aggregated to a national level the data says moderate (4.7%) but broad based house price falls in the last six months that are accelerating in the October/November period. Looking at the state based data I wanted to check if my two ideas from my previous post matched this set of data. These ideas were:
1. Prices holding up in Washington DC and New York, where the centres of power are, and weak elsewhere.
2. Prices not following the previous boom/bust cycle but basically also weak in areas that did not have real estate booms in the early/mid 2000's.

OK so point 1 the answer is yes. House prices basically flat last 6 months in District of Columbia (i.e Washington DC) and Rhode Island (New York) and down in practically every other state.

On point 2 the data is not so clear. I looked at the states that had price decreases greater than 6% over the last 6 months and checked whether they had previous price booms. 9 States had falls greater than 6% and only 3 of these did not have previous big booms (Alabama, Delaware, Missouri). In contrast 6 states where prices are dropping fairly rapidly had previously experienced the big booms (Arizona, Idaho, Florida, Montana, Oregon, Utah). Given that only about 35-40% of states previously had the big booms and that 66% (6 out of 9) of these were states where prices are now dropping the most rapidly it looks like some of the boom/bust cycle is still playing out in housing. So some states that did not have booms are now having the bust but other states that had the booms (particularly those adjacent to California) are having a second dip in prices.

My guess is there are more price falls to come at a national level over the next year (say 10%) but clearly there will be a fair bit of variation across states, cities, housing types etc. Apart from Washington DC and New York it still looks like the previous boom states are likely to fall the most.

US housing markets - strongish centre and weak periphery

The most recent Case-Shiller house prices (October data) for 20 cities in the US came out a few days ago. The overall impression is that house prices have begun to slowly weaken again following the expiry of the tax credit in April. This is relevant for the broader economy in terms of likely additional loses on loans, new building activity, wealth effects etc.

Previous patterns in house price movements between cities mainly reflected those that had booms versus those that didn't. Basically those that had big booms in the 2000's had big busts from April 2006 to May 2009. Those cities that missed the big booms didn't have big busts. Then from about May 2009 to May 2010 prices stabilised helped by government programs that propped up the housing market, lack of new house building, lower house prices, lower interest rates etc. An interesting new trend that is emerging is that the recent trends in house prices do not reflect the previous boom/bust cycle but rather the cities that are at the centre of the political/financial world are holding up while those that are at the periphery are falling.

Let's look at the figures over the last 5 months. New York and Washington are the only cities where prices are basically flat. Non boom/bust cities Portland, Cleveland, Minneapolis, Atlanta, Dallas down 4 to 6%. Although some boom cities are again trending down significantly (e.g. Phoenix (-8%), San Fransisco (-4%)) they are certainly not weaker as a group than the non boom/bust cities. So this recent weakening in prices is not largely related to the bust of the big booms, sub prime lending etc. but rather local economic weakness, high unemployment, high debt levels etc.

Looking back longer term we also see more evidence of the same pattern. In Washington and New York prices have only dropped around 25% since the boom peak. In other cities that have had booms the price drops have been 37% to 58%. So again Washington and New York stand out as the cities where prices have been relatively strong. So why? Well my first impression is simply that these are the cities where the economy has been propped up the most by the federal government. Clearly the financial services industry centred in New York has been propped up, big bonuses are back etc. While the federal bureaucracy which centres on Washington has been sheltered by keeping spending strong to cushion the impacts of the recession.

Clearly the data supports those who believe the federal government have helped those in the financial services industry and the federal bureaucracy system a lot more than those in "main street" who are far from the centres of power. Sadly even those who did nor enjoy the fruits of the unsustainable boom will continue to feel the lingering impacts of the bust in terms of weaker house prices and high unemployment. This picture fits in well with the broader disillusion of main street with wall street and established politicians.

Latest US house price data

OK the Case Shiller house price data is out today (for May). Last months data I pointed out an emerging trend.

"5 cities that did not have a big boom, the change in prices was basically 0 over the last 2 months (with a range of -2% to +1%, while in the boom cities the average was -3.8% (range -1% to -7%). Clearly a significant difference, both statistically and practically speaking. So the recent trend is that in the non boom cities prices are almost stable despite the rising unemployment while in the cities which had booms the price falls are slowing but still there. "

Let's see now looking at the last 2 months if this trend is becoming clearer or was merely a statistical blip. 5 cities that did not have a big boom, the change in prices averaged 1% up over the last 2 months (with a range of -1% to +3%) while in the boom cities the average was -1.7% (range 1% to -7%). So for non boom cities prices do appear to have stabilised while for the boom cities prices continue to fall but that rate of price decrease has slowed significantly compared to 3-4 months ago.

So what does this mean? Well it's probably not too bad a time to buy a house in the non boom cities. However most banks exposures to bad loans are in the boom cities and these are still falling though at a slower rate.

There has been some discussion amongst bloggers about problematic Option ARM loans and when they are likely to default. This discussion has centred on recast and rest dates when payments or interest rates change for these loans. See http://www.calculatedriskblog.com/search/label/Option%20ARM for a summary of Option ARM posts on the excellent calculated risk blog.

As I pointed out in my last post default decision are likely in most cases to depend upon changes in personal circumstances. So defaults are likely to be spread over time rather than bunched according to rest or recast dates. This is what appears to be happening now see http://www.calculatedriskblog.com/search/label/Option%20ARM. US banks face a long hard road ahead.

Forclosures - a short or long term problem?

Over at http://oldprof.typepad.com/a_dash_of_insight/2009/06/interpreting-housing-indicators.html Jeffrey A. Miller has a good post on seasonality in data and on house prices in particular.

On the latest Case-Shiller US housing price data the most interesting thing I found (based on the more reliable seasonally adjusted data) was that for the 5 cities that did not have a big boom, the change in prices was basically 0 over the last 2 months (with a range of -2% to +1%) while in the boom cities the average was -3.8% (range -1% to -7%). Clearly a significant difference, both statistically and practically speaking. So the recent trend is that in the non boom cities prices are almost stable despite the rising unemployment while in the cities which had booms the price falls are slowing but still there.


Looking to the future I look at two questions.
1. How are things going to pan out in the next 3-4 years and beyond for house prices in these various cities in the US?
2. How about foreclosures over this 3-4 year period?

OK house prices. Generally the futures markets and economic forecasters suggest some more falls in the boom markets over the next year or two (say 10-15%) then some flattening out. This seems a reasonable guess to me though of course there's a fair margin of error and clearly different cities and different market sectors are going to have different outcomes. e.g. the high priced end of the market in boom cities may have further to fall as price differentials have widened with the collapse at the lower end and there is a lack of "move up" buyers.

Now turning to the second question what is going to happen regarding defaults and the results modification, foreclosures, short sales etc. i.e. problems for banks. Most commentators give the impression that the foreclosure problem is related largely to sub prime and that as we have worked through a lot of this the problem will be largely gone over the next year as the worst of these loans would have already defaulted. On this basis they see bank losses related to the residential housing market as not being a problem beyond the next 12-18 months. I disagree for two reasons.
1. The recent data.
2. My hunches about why people will default and how often this will happen.

The recent data on delinquent loans (i.e loans where payments are more than 60 days late) show a steady and significant increase in each of the last 4 quarters in the proportion of prime loans going delinquent. Prime loans are two thirds total loans and are the "best quality" loans. So the data suggests a growing and broad problem not related to sub prime that is not going to go away when the majority of sub prime loans have defaulted. Sure you might say "but it's the recession dummy - its' people loosing their jobs and not being able to keep up with the mortgage payments". That's part of it but it's far from the whole story as I outline below.

Let's turn now to the reasons why people default and consider whether this is likely to continue over the next 3-4 years (and possibly much longer).

My hunches are that the main triggers for default are:

1. The pure economic motive. Some people default when they see the value of their property is much less then the value of their loan and they don't expect their house value to improve significantly anytime soon. I presume investors and many who bought near the peak of the boom are in this category. Basically many of the people in this category who were going to default have already defaulted so while this will be a continuing issue I don't see it being the main issue in the longer term unless it is teamed with the circumstances outlined below.

2. Defaults because the homeowner can't afford the repayments anymore. Clearly triggers here include: decreased income due to job loss, a reduction in working hours or being forced to take a worse paying job are going to be triggers. Also clearly this is going to be a big issue over the next year at least. However even when unemployment has stabilised there are still vast numbers of jobs lost and created in any year in a "normal" economy. Coming out of past recessions this has not mattered much to banks as for almost all homeowners their loan value was less then their home value. So the homeowner maybe forced to sell the house (but this caused the bank no loss), or take a second mortgage with the equity they had in the house, or borrow from relatives etc. However for the foreseeable future, in all the housing markets that had the big boom bust cycle, these options are either impossible or no longer in many homeowners best interests. It's in their interest to default. This means even in the years following the end of the recession there will still be substantial defaults where banks will loose substantial money on the foreclosure sale when people temporarily can't afford the repayments.

3. The same dynamic exists as point 2 for situations where some other change in life circumstances triggers a home sale (and where the loan value is greater than the house value). Examples of these circumstances include: moving to another area for job or family reasons, life cycle events that trigger a desire or need to move/downsize/upsize (divorce, marriage, death, birth etc). These are the normal factors that trigger most sales. For many of these people the new reality in "post recession" economic times will be that they will be better off financially by defaulting on their loan.

These three points suggest that, in the markets that had the house price boom bust cycle (i.e most metro markets), defaults and foreclosures are going to be commonplace long beyond the end of the recession. This has four significant implications.
In the post boom housing markets it will mean:
1. Foreclosures and short sales which will dampen any medium term rebound in house prices.
2. A negative impact on the profitability of new construction in those markets as house prices will remain subdued.
3. Ongoing losses over to those lenders that made (even prime) loans in these markets even after the recession passes.
4. Residential housing investment is unlikely to rebound as strongly as it usually does at the end a recession. This will tend to make economic recovery sluggish - especially in post boom markets (like the sunbelt) where the economic situation is already worse than average.

It is point 3 that I have yet to see mentioned in commentary.

Stock market - medium term outlook April 20

On March 19 on my last stock trading update I said.

"Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatility gentle trend upwards (as occurs in bull markets). "

Well I am still waiting! Markets worldwide have rallied a long way very quickly. I have basically continued making a Little money with short term trades but apart from small potatoes this rally has largely passed my by. Closed most short positions apart from one small one on the Spanish market and then opened a small new short on the US market on Friday.

I looked at stock markets in particular the US market from a macro perspective in January and then in February. The US market continues to lead other markets so remains the focus. Let's see how things as panning out from that perspective and what's changed. My new comments are in italics.

A. Economic fundamentals. Before things actually get better in the real economy the chronological steps we have to go through are:
1. Stop increasing the speed of deterioration
2. Continue to get worse but at a slower pace
3. Stabilise
4. Start to improve.

At this stage it appears we've reached point 2 the speed of deterioration has at least stopped increasing even though the speed of deterioration is still high. This is a step in the right direction in the last 2-3 months but still there's still a fair way to go and there are definite risks in ongoing problems given the underlying issues of high indebtedness and fragile financial systems still exist.

B. The scope of government action. The decrease in real GDP has occurred despite large stimulus and bank bailout measures and unprecedented monetary policy action. So there is not too so much more the governments can do without causing themselves significant long term problems (i.e. government deficits become to large for markets to believe they will be serviced and the Fed ends up lacking creditworthiness due to holding assists worth less than amounts lent).

No change here.

OK so that's the real economy but hasn't the stock market already fallen a lot and discounted these problems meaning we might have seen the bottom?

C. When in the economic cycle are equity returns usually strong? Research indicates that returns in stock markets are very high for 6 months starting in the last 6 months of recession or at the end of recession. So given we're very likely more than 6 months away from the end, and possibly years away, this suggests we should be vigilant for a possible stabilisation in the recession (particularly if its' not related to one off government stimulus responses which will have a temporary impact) but we shouldn't be too hopeful about strong equity returns from this point.

Some economists continue to forecast an end of the recession in 6 months time but they have been forecasting this for about a year now. We certainly seem closer to the end than 2 months ago but it's unclear if this is going to be an L or V shaped recovery at this stage and the finding on stock returns only applies to V shaped recoveries. Check out stock market returns in Japan over the last 15 years since their L shaped recession - terrible!

D. Are stocks cheap compared to earnings? Aggregation of earnings forecasts suggests that when looking at individual companies USA equity market earnings forecasts are way too optimistic given the bleak macro economic outlook. i.e. analysts forecasts are suggesting earnings will zoom up over the next year when clearly the economy looks tougher this year than last. Earning disappointments will lead to disillusion with the market and create strong downward pressure on prices.

Earnings forecasts have come down so there is less scope for disappointment but still earnings are on a downwards path and obviously stock prices have bounced so they certainly don't' look cheap compared to earnings. Based on the last quarter earnings for the SP500 of around $14 the PE of the market is around 60! Clearly banks losses will end at some point and that will drive earning up to maybe around 40 in the next year or two but even that is a PE above 20!

E. Are equity prices cheap compared to the asset values of the companies? Compared to valuation during the last few years yes prices are cheap compared to asset value. But historical standards during recessions equity prices are not cheap. Tobin's Q - The measure of equity prices to prices on assets on the books - is currently around 0.7 this typically bottom's at 0.3 during recessions. This suggests there is a long way to fall. i.e. over 50%.F. Are longer term technical indicators basing in preparation for a sustained rebound? Primary long term trends in all major stock markets are clearly down.G. What is driving equity term markets on a daily basis and does this gives us hope? Looking at the past 9 months the pattern in movement in daily stock prices is astoundingly consistent. Equity markets are rebounding based on possible government actions and falling on the reality of earnings and broader economic data. There is no other "story" of substance out there in the market. Given the size of the economic problem, governments cannot have an overwhelming impact. So once the reality of this hits the primarily stimulus in this market of this "Obama bounce" will be gone and traders will be focused on the bleak macro economic data and the bleak earnings data.

Stock prices around 1.9 times asset values so stocks are now more expensive than previously. Danger.

H. Will the new administration in the US make a difference? Sure they can take actions that will have positive impacts but they are still politicians in the same political, social, cultural and economic system and political/equity cycles suggest bad times ahead. Basically "on average" equity markets in the US perform well in the third and forth years of a presidential term and poorly in the first and the second years. My understanding of this is that in the third and forth years most presidents (and congress and the senate) worry about being elected next time so they need to get out there and sell a positive picture of the economy. However during the first two years they face the reality of not being able to fund all their promises and the opportunity to talk down things and blame their predecessor. No doubt Obama will "discover" things are a lot worse than he thought and he will not be able to follow through with campaign promises.

No change.

I. Buffet is buying so if I'm a long term investor isn't now the time to snap up some bargains? Yes Buffet has been buying (but generally getting a special deal rather than buying at market price as you would be). His interviews suggest he's buying based on his view that this is largely similar recession to the ones he has experienced since he started in 1954. There are two points here. One - this recession looks different in terms of the: possible insolvency of the banking system, the debt levels of the USA consumers and government and the massive bubble in house prices that still has a long way to bust . Two - Buffet doesn't try to time the market, he readily admits he usually buys in too early when the market falls and he buys stocks with very specific characteristics rather than the whole market (often at prices unavailable to others).

No change.

So in summary, things now look slightly more hopeful on the macro front but valuations are not cheap compared to usual recession values and there are significant dangers to any economic recovery when it occurs. One of these dangers is the damage that the unwinding of unprecedented Fed actions may cause. A second is the zombie banks, a third the perilous deficit and budget situations of governments worldwide and a forth the weak financial situation that consumers find themselves in the US and other developed countries I remain cautious in the market and continue to look for opportunities to short the market.

Stock trading March 19 2009

In my March 7 update I concluded.

"So large falls in the short term probably depend on the market coming to believe that:
a. Commercial real estate is some sort of repeat of residential real estate (hope Geithners stress test include defaults from builders on owners in this area - 25% of banks loans)
b. Insurance becoming part 2 of the banking crisis (again based on asset purchases with money that they need to pay back in the future - in this case to policy holders).
c. More panic in credit markets.

If not we could have a bounce despite continuing deterioration in economic conditions. "

Well we certainly had the bounce in stock markets! I closed down about half my short positions after the bounce lasted 2 days and other than that not much change. I am currently short the Spanish market and a small short on the French market. The European markets have generally only advanced in response to the US market jumping each day so clearly European markets do not have an upward momentum of their own at this point.

The so called good news that commentators have ascribed the bounce to has been hardly convincing.
1. Bernake saying the recession may end this year if everything goes right. Hardly news he's been saying the recession "may end in 6 months" for the last year.
2. Banks saying they are profitable (as long as they don't have to take count the losses).
3. Housing starts increased from virtually nothing to slightly above virtually nothing.

Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatilty gentle trend upwards (as occurs in bull markets).

US housing starts - unexpected jump

The blue line is all housing starts.

The figures graphed above show a jump in US housing starts and this jump is due almost entirely in a jump in multi-family housing starts (apartments, condos etc). The stock market liked this and jumped.

Three points stand out for me on this.

1. This seems to have caught people by surprise and resulted in a significant jump in the stock market. Should it be surprising if you understand housing markets?

No! Why - because there's not one housing market so we don't need to wait till all the inventory is run down in say Californian single family homes before we start building condos in Denver. For more details see my blog from January. IT is worth noting the jump in multi family housing starts was mostly in the north east of the country - an area with smaller boom and bust in housing. http://reflexivityfinance.blogspot.com/2009/01/misconception-2-housing-market.html

2. Is this indicative of a broad turnaround in housing starts?

Maybe in some segments but little change in main markets for the foreseeable future. In this vast majority of markets: housing prices are still decreasing, there is still too much inventory for sale (though this is gradually decreasing), foreclosures continue, rental vacancy rates are increasing and rental prices decreasing.

3. If there is s turnaround in housing starts over the next 3 months will it make a big difference to the real economy over the next 3-6 months?

Probably not. Housing starts have fallen to lowest on record. Even worse than the graph suggests if you factor in population growth. They need to increase 100% from this point to get back to a position where they would be considered terrible in any other postwar recession. So even if we get a turnaround it isn't going have a big dollar impact because it will still mean not a lot of dollars going into building. In addition dollars spent are related more to completions then starts and obviously housing completions lag housing starts considerably. Housing completions are still going to be going down for the next 3 months or more and then increase back to the level where we are now for the next few months. This is because housing starts have been going down rapidly for the last 3 months.

So in summary any rebound isn't going to start to translate into dollar impacts for at least 3-6 months and even then the rebound in dollar terms is going to be small because we are starting from an extremely low base and because many markets have significant inventory, low prices etc that will stop the rebound being a broad based one.

For more detail on the figures graphed above see http://www.calculatedriskblog.com/2009/03/housing-starts-rebound.html