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

What chance a US depression - update

A couple of weeeks ago I did some back of the envelop calculations on what the likelihood of a depression (as defined by a > 10% drop in real GDP) is in the US. I concluded:


"Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously"


Since then I've gone back and looked at various current figures on real GDP and found to my surprise that real GDP has only dropped about 1% since the start of this recession. It has just flat lined for about 15 months. Given this, I now believe it is less likely we're going to suddenly fall off the edge of a cliff and have a 10% plus GDP fall from here. So I'd say that given the impact of simultaneous crashes in stock and housing markets along with a financial crisis the powers that be have done a pretty good job at avoiding a real crash in real GDP (though a real bad job in piling up problems for the future and bailing out the undeserving and increasing the likelihood of 10 bad years ahead).

So what's my new guess on the probability of a US depression? Probably 50% maximum maybe a little lower.

On a more practical level I also suggested various actions that may help protect people from the consequences of economic deterioration ahead. Whether we have a depression or a long drawn out period of low growth these actions remain sensible steps in my view.

"1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.
4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8."

Stock trading update - March 7

In late Feb I summarised my strategy as:

"1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance. "

Since then I have:
1. Decreased the size of my size of my short position on US market and opened short positions on the following market indexes Spanish (largest position), French and UK. Basically the eastern European credit problem looks like it might be an issue and that on top of the hosing market related issues and economic contraction there was fast or faster than the US. In addition the European Central Bank has much less power than US Federal Reserve to aggressively take supporting action so they are in a more difficult situation if things continue to deteriorate.

This has worked well as the Spanish market is down 9.5% this month while US market only down 5.8% and The UK and French markets down around 6.5%.

2. Dipped my toe into small gold stocks in the Australian market when it looked like gold was strong. I sold most of the positions as the gold price weakened and manged to get out even through some reasonably good short term trading. Gold has now bounced off 900 and if it can hold above 920 there maybe another attempt to break strong resistance at $US1000. I am poised to jump back in if $920 support holds.

3. Doing a little less of my day trading in small cap stocks and managing to make a tiny bit of money in a steadily falling market which is good.

4. Concluded that there is little commercial property going to be built in the US in the next 2-3 years (in contract to the past year which has been fairly normal due to lags in planning/building etc). so looked for suppliers to the commercial property market in the US to short. Couldn't find any that looked ideal so gave up for now. Need to get back to that.

The economic news is basically still more of the same. Insurance stocks now being hit hard. Certainly there is potential for them to be forced to raise a lot of capital given that they invest premiums in the market before they need to pay them back and asset values have dropped across the board.

There is clearly a possibility of a significant bounce at this part if only because markets have dropped so far so fast. In addition residential real estate and banking stocks have dropped so far that more drops from this point probably won't have much impact on the stock market indexes.

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.