Saturday, April 11, 2009

The Fundamentals Of Market Bottoms

The Fundamentals Of Market Bottoms
Fundamentals Of Residential Real Estate Market Bottoms

By David J. Merkel, CFA, FSA.

Before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different. Tops and bottoms are different primarily because of debt and options investors. At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up. Option investors get greedy on calls near tops, and give up on or even short puts. Implied volatility is low and stays low. There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms. They spike multiple times before the bottom finally arrives. Investors similarly grab for puts many times before the bottom arrives. Implied volatility is high and jumpy.

As a friend of mine once said, "To make a stock go to zero, it has to have a significant slug of debt." That is what differentiates tops from bottoms. At tops, no one cares about debt or balance sheets. The only insolvencies that happen then are due to fraud [[or incompetence: normxxx]]. But at bottoms, the only thing that investors care about is debt or balance sheets. In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money leap or warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders. In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times. Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

Housing Bubblettes, Redux 10/27/2005

From my piece, "Real Estate’s Top Looms":

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved.
That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That’s why I think the hot coastal markets are bubblettes.
My position hasn’t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them. But what of market bottoms? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to "stay away from all stocks because of the negative macroeconomic environment", and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented. They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity. Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling. In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their assets under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then. M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.

8) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the "adults" more often. By adults, I mean those who say "You should have seen this coming. Our nation has been irresponsible, yada, yada, yada." When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom. The "chrome dome count", showing more 'older' investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains. They also buy sectors that are rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot— e.g. money market funds, collectibles, gold, real estate— they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in 'hedged strategies' reaches manic levels.

Changes In Corporate Behavior

1) Primary IPOs don’t get done, and what few that get done are only of the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut. Raising new money is hard; returns are low.

3) There are more earnings disappointments, and guidance goes lower for the future. The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying "So what else is new"?

4) Leverage is significantly reduced, and companies begin talking about how strong their balance sheets are. Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc. The weakest die. Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.

5) Accounting tends to get cleaned up, and operating earnings become closer to net (GAAP) earnings.As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

8) High quality companies keep buying back stock, not aggresssively, but persistently.

Other Indicators

1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.

2)The Fed adds liquidity to the system, and the response is sluggish at best. By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

There are some reasons for optimism in the present environment. Shorts are feared. Value investors are seeing more and more ideas that are intriguing. Credit-sensitive names have been hurt. The yield curve has a positive slope. Short interest is pretty high. But a bottom is not with us yet, for the following reasons:

  • Implied volatility is low.

  • Corporate defaults are not at crisis levels yet.

  • Housing prices still have further to fall.

  • Bear markets have duration, and this one has been pretty moderate so far [[considering the damage: normxxx]].

  • Leverage hasn’t decreased much. In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.

  • I don’t sense true panic among investors yet. Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I— and you— can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough. Exacerbating that will be all of the neophyte shorts that have piled on in this bear market. This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more). There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals. In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company— it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present. That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question. Long only investors must play defense here, and there will be a reward when the bottom comes.


Fundamentals Of Residential Real Estate Market Bottoms

By David J. Merkel, CFA, FSA.

This piece asks whether we are at the bottom for Residential Real Estate (RRE) prices. If not, then when, and how much more pain?

Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are not symetric. The signals for a bottom are not simply the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors. At market tops, credit spreads are typically tight, but they have been tight for several years, while seemingly cheap leverage builds up. There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.

To make RRE go to zero, it has to have a significant slug of debt. That is what differentiates tops from bottoms. At tops, no one cares about the level of debt or financing terms. The rare insolvencies that happen then are often due to fraud. But at bottoms, the only thing that investors care about is the level of debt or financing terms.

Why Do RRE Defaults Happen?

It costs money to sell a home— around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as a put option on the putative 'value' of the home, should they continue to pay on their mortgage.

As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 15%. It may go as high as 20% by the time we reach bottom.

Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:

  • Unemployment

  • Death

  • Disability

  • Disaster

  • Divorce

  • Large mortgage payment rise from a reset or a recast

These negative life events, which, aside from changes in mortgage payments, can’t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don’t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. As long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.

Examining Economic Actors As We Near The Bottom

Starting at the bottom of the housing "food chain," I’m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.

This presumes that the remaining banks are in good shape, with adequate capacity to lend. That’s not true at present. Regulation has moved into triage mode, where the regulators are "stress testing" to divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.

The Fed’s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.

Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for the surviving institutions.

Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.

Many other players in RRE financing will find themselves stretched, and some will be broken. Consider:

1) The number of home equity lenders will be greatly reduced, and won’t increase until well after the bottom is passed.

2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.

3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in "high quality" paper. Don’t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA, Ambac, and other financial guarantors, since they guaranteed similar business. How big will their losses be?

4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.

5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the this bottom arrives. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.

6) Securitization gets done in very limited fashion, if at all. This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do. My suspicion is near the bottom, as loan volumes increase, banks will be looking for ways to move mortgages off of their balance sheets, and securitization should increase [[probably with guarantees: normxxx]].

7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever mélange of programs the US uses to directly or indirectly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and, those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven’t blinked by now, I’m not sure what level of current account deficit would make them change their policy.

That said, the recent housing bill was probably too little too late. Look for the US Government to try again, probably later in the year.

A Few More Economic Actors To Consider

Now let’s consider the likely actions of parties that are closer to the building and buying of houses.

1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get one to buy the property.

2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.

3) At the bottom, only the best realtors are left. It’s no longer a seemingly "easy money" profession.

4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.

As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped "Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%." Well, we are past there, but I didn’t expect the TED spread to remain so high.)

5) Defaults begin burning out, because the number of properties in a negative equity on sale position begins to decline.

6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets. [[Californians, pay heed!: normxxx]]

For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.

When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late '90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late '70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can’t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.

The Bottom Is Coming, But I Wouldn’t Get Too Happy Yet

There are reasons to think that we are at or near the bottom now:

• Sales are increasing in a number of areas where foreclosures are significant.

• What little lending is being done is being done on relatively sound terms.

• Securitization has slowed dramatically.

• The major homebuilders are trading for 50-125% of book value, generally. The question is how much remains to be written down.

• New home sales have slowed dramatically. Homebuilder confidence is low and new construction has slowed to a crawl.

But I don’t think we are there yet, and here is why:

• Foreclosures are still increasing.

• Mortgage stress seems to be increasing in
prime and prime jumbo loans [[and there are still a slew of ARMs which will reset by the end of this year and 2010!: normxxx]].

• The inventory of unsold homes continues to rise. At the bottom, inventories will have started to shrink, but are not yet to 'normal' inventory levels. (There is also significant dark supply, or shadow inventory as well, which will feed into the market as prices stabilize or even rise.)

• The inventory of depository financial institutions in trouble [[including FHLBs: normxxx]] continues to rise. Regulatory triage is only beginning.

• We still have a lot of payment resets and recasts to go through. (
My, but those option ARMs are ugly.)

• FOMC policy is not providing a lot of liquidity to the economy as a whole, but only to a few lending markets.

• The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.

• The US Government will try some more policy ideas as the one's tried 'fail to meet the test'.

• We aren’t seeing a lot of speculative buying yet. [[Huge RE interests are waiting to pounce the minute they think a solid bottom has been reached.: normxxx]]

• The biggest regional booms have had the biggest busts, but
affordability has yet to be restored in many markets.

My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now. Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I— and you— can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks. [[But it is more than likely the weakest home builders will fold sometime this year.: normxxx]]



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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