Wednesday, June 23, 2010

Time to Start Nibbling on Housing Sensitive Stocks

With new home sales down 32.7% in May, the housing bears are once again gaining an audience with the media. While there is little doubt that housing remains in the doldrums, I am getting increasingly bullish at today’s levels and believe that investors with a longer-term time frame (at least 1-2 years) should think about dipping their toes into housing related stocks. The 30%+ declines in many homebuilders over the last few months provides an attractive entry point for those willing to look past that bevy of seemingly bad news over the last few weeks.

Firstly, the huge swoon in May largely reflects the falloff in activity post the expiration of the $8,000 tax credit on April 30th. Homebuilders aggressively built inventory in the first four months of 2010 in anticipation of pulling would be buyers into the market. As such, we saw new home sales increase by 12.1% in March and 14.7% in April, so naturally we were going to see a steep decline in May. Admittedly, 33% was worse than most pundits expected, but I firmly believe that May’s print will represent the trough in this brutal 5-year housing downturn. To put the 300,000 new home sale in context; this is 8.8% lower than the previous lowpoint (329,000 annualized homes sales in January 2009 – two months after the first tax credit was slated to expire) and a staggering 78.4% below the peak number set in July 2005.

Secondly, the standing inventory of new home sales continues to hit cycle lows (see chart below). In my opinion, this represents a more critical data point to gauge the health of the housing market, since the actual sales number has been significantly distorted by the expiration of the tax credit. May inventories were down 26.7% year over year, 62.7% from the cycle peak hit in June 2006 (nearly one year after the peak in new home sales), and lower than any level since data was first recorded in 1970. So while it is difficult to gauge when sales will pick up with any vigor, the low level of standing inventory suggests the industry is in a substantially healthier position and could realize some unexpected pricing power when things inevitably begin to pick up. A good article in today’s Wall Street Journal ("Beaten Down Markets Finds New Fans") highlights the rapidly declining inventory of finished home lots in several of the nation’s most overheated housing markets. Rising land prices inevitably serves as a precursor to higher home prices.

Affordability also should provide another floor on both pricing and volumes. With a peak to trough decline of 33% in home prices (see chart below) and mortgage rates under 5%, today has never been a better time to purchase a home for those waiting patiently on the sidelines. Further, the government remains extremely supportive of the housing market through its 1) commitment to keep long-term interest rates down (however, distortive these actions may prove to be); and 2) its backstop of the mortgage program through the FHA and GSEs. My firm believe is that the government will continue to flood the market with liquidity should evidence of a double dip begin to gain more traction. Multiple speeches given by Bernake suggest that he will do whatever it takes to stabilize the economy no matter how damaging said actions are on the federal balance sheet.
In conclusion, while concerns in housing have begun to resurface, I think the structural rebalancing that began in June 2005 is nearing its final stages. As with any market, the tendency to overcorrect is highly probable and investors should expect significant volatility over the coming quarters. However, my bias is always to invest when valuations have troughed and fundamentals have meaningfully improved.  The upside to today's dismal new home sale number is that the data could hardly get any worse; given how difficult the housing space space has been for the last 5 years that in and of itself is cause for celeberation.  For those with a longer-term time frame, investments made at the bottom of the cycle should prove prescient in years to come.

Friday, June 18, 2010

China's Share of Global Demand by Commodity

Here is a great chart I pulled from a recent BHP Billiton presentation that shows China’s share of global demand by commodity. Amazingly, China accounts for 63% of metallurgical coal demand (key ingredient in steel production), 56% of iron ore consumption (again, key raw material in steel production), 39% of aluminum demand, 36% of copper consumption, and 35% of global nickel consumption. 

Wednesday, June 16, 2010

Long Beach Container Shipments Showing Healthy Growth

Data on container shipments into the Long Beach Port in California provides an excellent snapshot into the overall economy, particularly as it relates to trade with Asia. As indicated in the chart below, inboard container shipments have experienced significant year-over year growth, with May 2010 shipments growing nearly 27%. Since bottoming in February 2009 (one month before the equity markets bottomed), shipments have grown by a staggering 77%, though remain well below the peak levels of 2007, as evidenced by May 2010 shipments which were still 16.4% lower than May 2007 shipments.

However, for those bullish on the US economic recovery, data from Long Beach certainly helps support that view. 

Spain's Monthly Funding Requirements - Watch July!

As demonstrated in the chart below, Spain faces a substantial funding gap in July, with 25 billion euros maturing during the month.

The country plans to access long-term capital on Thursday with the sale of 4% bonds due 2020 and 4.7% bonds due July 2041. Not coincidently, several press reports have come out suggesting that Spain is in discussions with the ECB and IMF regarding a bailout. Though Spain has vehemently denied these reports, a disappointing auction on Thursday could expedite said discussions. A seize up of interbank lending in Spain has already forced Spanish banks to borrow record amounts directly from the ECB. According to the FT, Spanish banks borrowed €85.6 billion from the ECB last month, more than double the amount lent to them prior to the collapse of Lehman and up from €74.6 billion in April ("Spanish banks break ECB loan record"). In my opinion, given Spain’s devastated economy and weakened banking system, it is only a matter of time before the country directly taps emergency loans from the ECB’s €440 billion stability fund.

However, as a true cynic, I believe talk of an IMF bailout of Spain has been purposely leaked in order to encourage investors to participate in the upcoming auction. Hank Paulson’s analogy about having a bazooka in dealing with Fannie & Freddie serves as a useful illustration in understanding the tactics employed by the ECB in attempting to avoid a direct bailout of Spain. Here is Paulson’s quote:

To Senate Republicans worried they’re being asked to write a blank cheque for federal support to mortgage brontosauruses Fannie Mae and Freddie Mac, Treasury Secretary Henry Paulson offered an intriguing analogy on Tuesday: “If you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it … you’re not likely to [have to] take it out.” In other words, give me an unlimited line of credit and I probably won’t have to draw on it. But give me X billion and force me to come back for more in three months after that hasn’t worked, and you’ll persuade people the U. S. government is powerless. Then where will we be?

Friday, June 4, 2010

More on the China Property Bust

As demonstrated in the chart below, April home prices in Beijing rose by a staggering 95% year-over-year vs. a nationally reported figure of 12.8% (though dividing total sales value of homes—384.6 billion yuan ($56.3 billion) in April—and the floorspace sold (72.4m square metres) yields growth of nearly 18%).

While there is little doubt that home prices are set to decline in China, low levels of personal and government debt should help lessen the damage from a property bust. As highlighted by the Economist (“China’s Economic Boom Can Survive a Property Bust”), the ratio of mortgage debt to GDP is only 15.3% in China, compared with a peak of 79% in America. The article highlights the example of Hong Kong’s late 1990s property bust to demonstrate that huge equity cushions should mitigate substantial damage to China’s banking system (unlike in the US and Europe). More specifically, in Hong Kong, where regulators bar mortgages of more than 70% of a home’s value, prices fell by almost half in the three years after the Asian financial crisis, yet mortgage delinquencies peaked at 1.4%. Finally, while mortgage books have grown by more than 70% for certain Chinese lenders, mortgages represent less than 20% of loans for most big banks, and loans to property developers account for perhaps another 8%. As such, banks have substantial capacity to absorb losses in the property sector, even if prices decline on the order of 25-30% (which is a distinct possibility given the massive run up we have seen).

While local government debt represents another distinct threat to the overall economy, particularly since they are heavily reliant on the property sales to fund their budgets, the article suggests these concerns may be somewhat overblown. According to Vincent Chan of Credit Suisse, land sales and property taxes should account for less than 17% of their revenues this year. Further, even if one uses an aggressive estimate of the debt carried by these local entities (11.4 trillion yuan as per calculations done by Victor Shih of Northwestern University), total public debt to GDP would be a manageable 50% of GDP, hardly alarming for an economy growing at over 10% in nominal terms and possessing $2.5 trillion of foreign currency reserves.

China's Property Market Slowing Down Sharply

Further evidence is emerging that China’s property market has begun to slow, as suggested in the chart below (see: China’s Property Market Freezes Up”). As discussed before, the Chinese government implemented several measures in April, including raising minimum downpayments on second homes to 50%, to help cool the market. On average, the number of residential property transactions in the four weeks after the curbs were unveiled is down 40% compared with the four weeks before the measures, according to figures covering 24 major cities from real-estate consultancy The sharp slowdown comes as Beijing considers additional measures to push down prices, including imposing new taxes on residential property (though I suspect this will be reconsidered in light of the sharp slowdown already impacting the market).

Similar to the beginning stages of the US property bust, real estate agents and local investors are dismissing the slowdown as a short-term phenomenon. While they recognize that business has slowed, one gets the sense they view the dip as a buying opportunity. This quote from a Chinese real estate agent captures the complacency of the average Chinese person about the potentially serious consequences of a protracted property bust.

“What’s really dampened the market is the uncertainty. That overhang is what’s driving everyone to wait,” said Kevin Yung, executive vice president of IFM Investments Ltd., which runs the Century 21 real-estate agency franchise in China. “We think this could last another three to six months,” he said, a rough forecast shared by other industry executives. “We think prices are going to come down, probably by about 20%, but it will happen over time because this adjustment is driven more by policy than demand” he said.

Thursday, June 3, 2010

Warren Buffett Comment on Muncipal Bonds

Warren Buffett famously called derivatives “financial weapons of mass disruption” way before anyone realized the systemic danger they posed. Regarding municipal debt, I think the following statement spoken at yesterday’s Financial Crisis Inquiry Commission will prove equally as prophetic:

“If you are looking now at something that you could look back later on and say, ‘These ratings were crazy,’ that would be the area,” Mr. Buffett said about state and local government bonds. “If the federal government will step in to help them, they are triple-A. If the federal government won’t step in to help them, who knows what they are.”

Tuesday, June 1, 2010

Strategic Defaults Threaten Housing Recovery

One of the biggest concerns weighing on the housing recovery remains the threat from “strategic defaults” by underwater homeowners (estimated at 25% of US households). With the backlog of foreclosures overwhelming the capacity of banks and mortgage servicers to deal with them, many homeowners are able to live rent free for months and potentially years on end. As suggested in the chart below, the average time it takes for a defaulting household to actually lose their property through a foreclosure has increased 75% since 2008 from 251 days in January 2008 to a staggering 438 days as of April 2010. The most egregious state is New York where the average homeowner spends 561 days in foreclosure, following closely by Florida at 518 days. Understaffing banks, government pressure to offer modifications, and incessant legal challenges have allowed millions of homeowners to live rent free, which in my opinion is creating an artificial boost to consumer spending, despite persistently high unemployment. With $2,000 or so freed up from not having to pay one’s mortgage, much of that money is being directed into other parts of the economy.

Some great quotes from a New York Times article (“Owners Stop Paying Mortgages, and Stop Fretting”) on the subject include the following (note how easy the profiled people are able to rationalize walking away from their contracts):
- More than 650,000 households had not paid in 18 months, LPS calculated earlier this year. With 19 percent of those homes, the lender had not even begun to take action to repossess the property — double the rate of a year earlier.
- One reason the house is worth so much less than the debt is because of the real estate crash. But the couple also refinanced at the height of the market, taking out cash to buy a truck they used as a contest prize for their hired animal trappers. It was a stupid move by their lender, according to [the homeowner] Mr. Pemberton. “They went outside their own guidelines on debt to income,” he said. “And when they did, they put themselves in jeopardy.”
- Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino. “Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”
- In Pinellas and Pasco counties, which include St. Petersburg and the suburbs to the north, there are 34,000 open foreclosure cases, said J. Thomas McGrady, chief judge of the Pinellas-Pasco Circuit. Ten years ago, the average was about 4,000. “The volume is killing us,” Judge McGrady said.
- About 10 new clients a week sign up, according to Mr. Stopa, who says he now has 350 clients in foreclosure, each of whom pays $1,500 a year for a maximum of six hours of attorney time. “I just do as much as needs to be done to force the bank to prove its case,” Mr. Stopa said.