Why Real Estate Prices Won't Bottom for Another 5 Years

I am very underinvested in real estate, and have been since we sold our apartment in NY in 2005.  At that time, I thought the market had peaked.  I was wrong, but not too far off.  We rented for 2 more years, then moved to NC where we bought a nice house. However, I have bought no land, nothing commercial, nothing in the equity markets and hence have stayed quite underinvested in real estate for years now.  Today, the Case-Schiller numbers hit a low not seen since April 2009.  Is it time to buy yet?

First of all, take a look at a long term chart of real estate prices, courtesy of Barron's this weekend.

The price scale on the right is the Case-Schiller index value, and today was reported to be 139.  That was down 3.3% from a year ago.   Home prices are still falling.  The peak index value was over 200 during our (now obvious) bubble, and before the bubble, prices hovered in the 110-120 range.  So perhaps we aren't far away from the bottom.  However, housing fell way below its long term trend during the 1920s through the 1940s.  That is entirely possible here.  This chart scares me to be honest.  What will stop the falling knife?

As far as the bull case for housing right now, usually it goes something like the following: "Housing starts (ie new builds) are today only 500,000 homes per year.  And with 1.5mm of new home demand per year on average, then we are depleting inventory rapidly.  There are 3.6mm homes for sale today, so we will have housing shortages very soon."  Hmmmm.

DEMAND FOR HOUSING
To gauge demand for housing, you have to exclude retrades and resales, and look at what really drives long term demand for housing.  While average population age, income and birth rates all matter, essentially net population growth in the US is what drives NEW demand for housing.  Furthermore, if you eyeball the housing demand chart over a very period of time it has equated to around demand growth of 1.4-1.5mm homes per year.  The NAHB also forecasts that long term housing demand for single-family units will grow at 1.5mm homes.  (Personally I think it will be lower, as immigration rates have slowed in the US, and aging populations tend to downgrade from houses to condos or smaller homes, lessening demand).

Nevertheless, using 1.5mm of annual housing demand less 0.5mm of new builds equates to net new demand of around 1mm houses per year in the US. 

Next, I'll take a look at our housing supply.  Because at the end of the day, until supply gets absorbed, we are very unlikely to see any meaningful housing appreciation.

SUPPLY OF HOUSING
First of all, the bull argument for housing entirely ignores the fact that the inventory of homes for sale is greatly understated.  Yes there are 3.6mm homes on the market right now.  But there are also piles of homes owned by banks, and also homes in the foreclosure process that will eventually hit the market.

The breakdown of our country's housing stock more accurately looks like:

1.  Houses for Sale Today:  3.6mm.
2.  Houses Foreclosured On (that is owned by Banks):  2mm
3.  Shadow Inventory:  2 - 3mm homes.  Shadow inventory refers to housing that is "seriously delinquent."  When a homeowner is 90 days or more behind on his mortgage, or is in the process of foreclosure, then that home is considered shadow inventory.

Total Housing Inventory:  around 8mm homes.  Alan Abelson was right on this weekend in Barron's.

So, comparing 8mm of home supply by the net new demand for housing of 1mm homes, means that we have 8 YEARS of supply in the market. That is a far cry from 6-12 months of supply, the level that is commonly cited as bullish for prices.  Or to use the SAAR number of 4mm (just the seasonally adjusted number of homes sold per year), when we have true inventory below 6 months, ie 2mm homes of inventory, then prices tend to rise.  8mm homes is years away from there.  At least 4-5 years. 

(By the way, much of this data came from the Mortgage Bankers Association.)

One of the issues backing up the pipeline of homes for sale has been the bruhaha over foreclosure proceedings.  Because so many mortgages were made, then sold, then re-sold, the paperwork became a disaster.  The well publicized robo-signers, who admittedly had no idea what mortgages that they were transferring, have enabled many receiving foreclosure notices to stay in their homes much longer.

In fact, last year there were 2.9mm homes that received foreclosure notices.  However, only 1mm of those were actually foreclosed on.  The process has gotten extremely backed up not only due to sheer volume, but also because banks are being much more careful now in the foreclosure process.  But that means we have significant shadow inventory that will eventually hit the market, and continuing to add to the supply glut over the next 2-3 years.

ANOTHER METHOD
Another way to look at the housing supply is by examing census data on vacancy rates.  Over time, vacancy rates of homes in the US have been remarkably stable, averaging around 14mm homes.  This is true since 1990, and also true going back to the early 1970s.  Many of these are summer homes, and many are bank owned, foreclosed homes.  I assume for simplicity, that all of the 14mm average number, are summer homes.  In effect, this somewhat adjusts automatically for rental houses, ceterus paribas, that is, assuming generally that the rental market is somewhat stable as well over time.

So today, we have 18.7mm vacant houses in the US.  Comparing that to our LT average of 14mm, I think its pretty clear that we have around 4.7mm excess homes in this country.  Combining this with shadow inventory (which likely aren't vacant, yet), and you also get around 7.2mm of housing inventory.

Very close to 8mm of housing inventory.  Way too much supply.

THE RENT OR BUY ANALYSIS
To me, our first housing purchase was simple.  It cost one $2500-3000 to rent a one bedroom apartment in NY, or with a mortgage, you could buy a place and pay $2000 a month for a similar one bedroom.  This was 1999, and I didn't quite understand the disparity.  I mean, with a mortgage, I am essentially locking in my rent for 30 years (with a fixed rate mortgage)!  With a rental unit, who knows what my landlord will charge me next year, or in 5 or 30 years.  But rent was definitely going higher.  Clearly, real estate prices were poised to go up, at least until buy prices caught up with rent prices.

I point this out because today I see houses in our neighborhood that rent for $2700 a month, but would cost you well over $3,000 a month with taxes and a mortgage.  The "buy" monthly payment is still higher than the "rent" monthly payment.  Depending on where you live, to me this is critical as a first step in examining where the real estate market is heading.  I suspect that the "buy" price will be lower (perhaps much lower) than the "rent" price when we reach the bottom.  However, looking at the chart below tells me that much of the excess premium to buy a home is clearly gone.  Still though, it costs more to buy, and bubbles are almost always characterized by bottoms well below trend. 

INTEREST RATES
I also hear that it's the best time to buy now because interest rates will never be lower.  That is true, and to me locking in a 15 year or 30 year fixed mortgage is a great idea.  If you have an adjustable mortage, even if it's 5 years out, I would refi into something fixed.  We are going to inflate our way out of massive fiscal deficits, and that means rates eventually are going higher.  Maybe much higher.  Don't be lazy and get blasted in 4 years when your ARM resets.

However, I wouldn't bet that low rates alone are enough to entice buyers and end the real estate bear market.  Even in 2009, with $8,000 tax credits on new homes, and artificially low rates, real estate prices barely stayed flat. 

What I think people miss about interest rates is, the entire mortgage market in our country has been nationalized.  Fannie Mae and Freddie Mac today purchase 70% of all mortgages made in the US.  Who is going to lend you money on a mortgage when they get phased out?  (that is Tim Geitner and the Obama administration's plan).  While this will likely take years, it means that mortgage rates are artficially low today, subsidized by taxpayers as lenders, compounded by the mortgage interest deduction (which may or may not stay in place).  At the end of the day, the private market cannot absorb the size of our mortgage market at current rates, rates will have to go up. 

And, as rates go up, prices generally fall.  During the 1970s, housing dragged as rates skyrocketed.  See below, prices were actually down for much of the decade, adjusted for inflation. 

CONCLUSION
The rent or buy analysis seems to indicate that housing hasn't fully normalized.  The supply of housing also still seems very high.  And prices compared to long term trendlines have still not quite gotten to normalized levels.  All of this tells me that housing prices will continue to suffer. 

While prices have fallen from 200 to 139 per the housing index, a 30% fall, it seems likely that prices will fall another 10-20%.  I think its most likely we'll see 120 again on the housing index.  Most housing bear markets last for many many years.  New York prices fell from 1987 until 1995.  Texas housing fell from 1981 after the oil bust, and didn't recover until 1999. We had a tremendous national housing bubble, and working off the excess is not a five year endeavor.  More likely, its a ten year readjustment period, perhaps longer.  Meantime, my recommendation is to keep real estate exposure as low as possible.

If anyone has any short ideas in the equity markets (apart from St Joe JOE, or XHB, neither of which I can get a borrow on), please forward my way.  Thanks!

Is the Bull Market Almost Over?

With earnings season underway, I was trying to gauge how much more upside we had to this bull market.  While I cannot predict or guess what will happen in the next quarter or two, I wanted to understand the upside/downside cases to the S&P over the next 5 years. 

Along those lines of thinking, I sought out some market research on S&P returns at various times in history.  For example, I found a great academic paper written in 1997, illustrating why S&P returns would be most likely very weak over the following 5 years.  He was right, the market was about flat, and everybody and their brother was extremely bullish then.  For the record the S&P was up a little, 6% cumulatively in the following 5 years, but with terrible up and down volatility.  Bonds did a lot better.

I was also reminded of a conversation that we (at one of my old hedge funds) once had with Warren Buffett.  This was 8 or 9 years ago, but very relevant to today.  Buffett discussed why the stock market environment was so perfect in 1980.  As I recall, he noted that, at that time, profit margins were at historical lows.  Not only that, but P/E ratios in 1980 were also at near all-time lows in the single digits.  With tightening monetary policy under Paul Volcker at the time, it was most likely that interest rates would go down.  They did, and, typical of markets, P/E ratios tend to move up when rates go down.  (we all know that stocks are merely the discounted value of their future cash flows, so if rates go down, valuations and P/Es go up).

So the next 20 years were fantastic for equity market investors in the US.  Margins improved dramatically, and valuations improved as well.  Fast forwarding to today, I basically wanted to paint a Jeremy Grantham-esque type picture of what I think the markets will do for the next 5 to 10 years.  In essence, market prices depend on a range of factors: current earnings levels, expected growth in earnings, interest rates, profit margins, and where you can expect to sell stocks at the end of the period.  That is, what kind of P/E ratio will the market trade at in 5 years, when you sell your equities? 

EARNINGS
So first of all, let's examine earnings.  What will earnings look like in 5 years?  What I found in doing some digging was that REAL earnings growth has been quite stable over a very long period of time.  By real, I mean adjusted for inflation.  Turns out, since 1930, S&P earnings have grown (on average) at a 1% real growth rate per year.  That answers one question, that is, what will the E in P/E be in 5 or 10 years.  However, I also noted that profit margins tend to swing pretty dramatically too, mostly due to the boom and bust nature of our economy.  But, most importantly, it has to be noted that profit margins are strongly mean reverting. 

Take a look at this chart on profit margins over dating back to 1955.

While this chart isn't updated to today, I found that we had a very similar dip in margins in 2008 and 2009, with a bounce back to the highs again in 2011.  Today, Q1 S&P 500 profit margins are hitting near peaks at 8.4%, versus a historical range of 5.5% to about 8%.  Furthermore, I found that since 2000, profit margins have averaged 7.3%, about 1.1% lower than today. 

So, if you think that profit margins continue to expand, then likely you will view the market as very cheap.  However, the inevitable recessions mean that we will more likely see profit margins falling, then rebounding again during the next recovery.  I do note, however, that today's unemployment rate at 8.9%, a very high number historically, means that there will be less wage pressure, and margins may remain higher than historically was the case.  The huge fall in margins in the chart above, in 2000, was likely due to the fact that a recession, coupled with sub 5% unemployment, meant corporations couldn't cut wages at all.  Net net, margins got crushed.  Likely it wont be as severe during the next recession.

INTEREST RATES
Historically, P/E ratios tend to be tied to rates.  When rates are high, as in the late 1970s, P/E ratios tended toward the 7-10x range.  When rates are low, P/E ratio's tend toward the higher end of the range, about 15-20x.  So, what is the right assumption in 5 or 10 years for rates and P/Es?  I don't honestly know, but I would say that we are far more likely to see higher rates (and lower P/Es) than we have today.  I wouldn't be surprised if we had 4-5% inflation in 5 years, and P/E ratios in the 10-14 range. 

So, let's look as some scenarios.

SCENARIO ONE (OPTIMISTIC CASE)
Let's assume in 5 years, we have similar high profit margins of 8.4%, that real earnings grow at 1%, and that P/E ratios are 13-17x.  Here is what S&P 500 returns look like:

S&P EPS: $114

5 Years		P/E Ratio in 5 Years
	13	15	17
S&P Level	1,809	2,087	2,365
Appreciation	3.20%	4.69%	6.01%
Dividends	1.78%	1.78%	1.78%
Total Return	4.98%	6.47%	7.79%

Not bad, 5% to almost 8% per year returns.

SCENARIO TWO (EXPECTED CASE)
Let's assume in 5 years, we have profit margins of 7.5%, which is slightly above the average margin since 2000.  Real earnings grow at 1%, and P/E ratios are between 10 and 14x.  I call this the most likely case, as 1) profit margins will remain higher than historicaly averages, given high unemployment today.  2) interest rates likely will go up with inflation and deficit issues in the US, causing lower P/E ratios than we see today.  So, given that, here is what S&P 500 returns look like 5 years out:

S&P EPS: $99.39

5 YEARS		P/E Ratio in 5 Years
	10	12	14
S&P Level	1,021	1,225	1,430
Appreciation	-2.53%	-0.74%	0.80%
Dividends	1.78%	1.78%	1.78%
Total Return	-0.75%	1.04%	2.58%

 

Not that exciting.  I am getting annualized returns between -1% and 2.6% per year. 

DOWNSIDE CASE
One has to consider the downside case to get a feel for risk reward overall.  If the upside is 7% per year, and the downside is flat, then you should probably be in stocks.  Let's take a look.

I assume we have a better outcome than 1980, although with inflation worries creeping into the picture, I would posit that the probability of this outcome is far from remote, and quite high, perhaps 20-30%.  Here I assume we have 6% profit margins, and 7-11x P/E ratios, both better outcomes than we saw in the early 1980s.

S&P Earnings: $82

5 YEARS		P/E Ratio in 5 Years
	7	9	11
S&P Level	572	735	899
Appreciation	-8.03%	-5.68%	-3.77%
Dividends	1.78%	1.78%	1.78%
Total Return	-6.25%	-3.90%	-1.99%

This is pretty ugly, and not terribly far off from what happened from 2000 to 2010.

S&P FAIR VALUE TODAY
Perhaps a better way to look at this would be to ask, what is fair value of the S&P today?  That is, given the case we are expecting 5 years from now.  That is easily determined, all one has to do is discount that future S&P level by the rate of return we think is appropriate for stocks.  Simply put, what kind of return would you demand to own stocks for 5 years? 

Given long dated bonds are yielding 4.4%, I would think that something in the 7-9% neighborhood makes sense, which is about a 4-6% real return given inflation today.  So, if the S&P could be around 1225-1430 in 5 years under our expected scenario, that equates to an S&P fair value estimate of around 960-1120.  These are levels where I would meaningfully add exposure to US equities. 

CONCLUSIONS
So today, we have equity markets trading at average P/E ratios, but against peak margins.  I suspect this points to full valuations, and certainly the US market is not cheap.  This chart brilliantly illustrates how bullish sentiment tends to get too high, but mostly when margins are at their peak:

We are currently in the highest 20% of margins.  In fact, probably in the top 5%.  However, at least the median P/E today of 15x isn't as high as the 25x in the chart.  Nevertheless, its clear that market tops form when profit margins peak, and vice versa.  I should point out though, that its possible that we WILL get 20x P/E ratios in the next 1-2 years, as bullish sentiment becomes a full bubble, indicating that the market could top 1600-1800.  I wouldn't make rational investment bets with this possibility however, and honestly find its more likely we'll have a pullback/correction after QE2 ends this June.  So, clearly we aren't in bubble territory yet, just a fully valued market.  I think holding 25% of my assets in stocks, another 10% in precious metals makes a lot of sense.

Finally, as per bonds, research shows that when bond yields are materially lower than S&P earnings yields (the inverse of the P/E, not dividend yields), then it doesnt bode well for fixed income, although its less conclusive on the market's direction.  Sell duration, own perhaps 25% in equities, and keep some commodity exposure as inflation insurance.

Stocks I am not Buying, Wine I am buying

I have almost done zero trades in a month now.  Most unusual of me, but I havent seen anything really interesting to buy.  (for the record, I did add some TEVA at 49, and probably will buy some AAPL around 325 if it gets there next week).  I am glad I passed on Japan though, EWJ is down as the yen continues to weaken.  So much of investing is just going along with what central banks are doing.  That is, if the Fed is easing, then own stocks.  If G7 countries are coordinating efforts to weaken the yen to help exporters there, then don't own yen-denominated assets.  Fighting the tape is a game I play sometimes, but generally it is just a bad idea.  And the biggest influencer in the equity markets are central banks, pure and simple. 

When QE2 ends in June, I really wonder what will happen to rates.  Ironically, when QE1 ended in 2010, the economy immediatley begain to weaken, stocks fell, and treasuries rallied in a flight to lower risk assets.  When QE2 was announced at the end of last August, rates spiked, and hence treasuries fell.   Because the reality is that pumping money into an economy is effectively stimulus, leading to inflation, an overheating economy, and in those environments rates and equities tend to move up. 

So what is an investor to do?  I don't know.  I don't have the playbook because really we are just at the mercy of the Fed.  "Bubble's" Ben Bernanke will likely push through QE3, but with real inflation showing up all over the world, there is probably enough pressure here to keep him from going there.  For now.  Eventually he will implement QE3, but with inflationary pressure building, I think monetary policy and QE will pause.  As will the market.  

Last year the Fed paused for 5 months between QE programs, from March to August's announcement of QE2.  And the market fell 15%.  This time we might get the same pause and a similar, perhaps larger correction. Which won't be good for risk assets, and why most market watchers are calling for caution right now.   

So, on an off topic, I thought I would talk about my favorite wines since I am not buying stocks.  I have always had people ask me to recommend bottles, and so here goes.  Enjoy.  If you are looking for white wine ideas, you can just skip this!

Wine I am Buying
First of all, I don't ever buy wine as an investment.  I drink em.  That said, I have found many times that the $50 bottles I have picked up, are auctioning for $100-120 three to five years later.  That is, when I drink 'em I sometimes check to see what I could get elsewhere for them.  I figure its partly a devalued dollar, and partly the peaking of the wine.  Who knows.  Once I read that one wine afficionado would buy a case of wine for $50-100 a bottle or whatever it cost.  And in 5 years, sell half of them, hopefully at double the price to mean he was drinking his remaining wine for "free."  More work than I want to deal with, but worth considering.  The right wines do go up in value.

So, here is my list of recent buys, by price range.

$15-30 Wines
First of all, I rarely buy wine below $15, and never below $10.  There is massive inefficiency in the wine world, but not so much that you'll find great wines for $10 or $12.  Good, enjoyable wines, yes.  Great, age-worthly lip-smacking wines.  No.  But I have found these to be quite good, some worth cellaring for 2-5 years:

Gotham 2008 McLaren Vale Shiraz  - about $15.  drink now, great stuff, nice full bodied and fruity shiraz. 
Story Winery Picnic Hill Zinfandel 2007 - about $25 or so for a bottle, you can find these at the winery's website.  I owe my wine-snob of a brother Chuck (I mean that in a good way!) kudos for introducing this one to us.  Buy it by the case, the best Zin I have ever had.  It becomes velvety like an aged Pinot at about 5 years of age, when it peaks.
Craggy Range Te Muna Pinot Noir 2008 - 93 points, Wine Spectator calls this a top 100 wine of 2010.  We downed a few bottles of the 2003 version recently, and it was fantastic.  I have a case of this one, its around $30.  Year in and year out it gets 93-95 points by the wine critics.  It ages extremely well from what we saw in the 2003 bottle that we just recently drank.  I actually expect to start cracking these 2008s in 2013-2014.

$30-75 Wines
I am going to veer into the Shiraz category here, because you just can't find so many top flight, rich full-bodied amazing wines for the price than you can out of Australia right now.  We have been blown away literally by these wines in the last few months:
Mollydooker the Blue Eyed Boy, 2007 or 2009 - Shiraz, Australia.  We have both the 07 and 09 versions.  They only make these bottles in top quality vintages, and 2008 didn't pass the test.  So, check out the other years.  This stuff is a meal in a glass, you can literally chew on the wine as you drink it.  Inky dark purple, very very serious not for the feint of heart.  Around $45.  Great value.
Glaetzer Amon-Ra 2004 Shiraz - 95 points, around $65.  Rich, Barossa Valley classic from a top wine maker in Australian.  This stuff is truly awesome.  The finish goes on and on, and you just need the smallest sip of the wine to get huge body and fullness and flavor in your mouth.  Take this to a steakhouse.  We did a week ago, and the 2004 was still too young.  Find a couple of these, put them away for 2-4 years and then drink them.  I am not sure I have ever had a better bottle than this, anywhere.
Mitolo GAM shiraz 2005.  Another wine rated 95 points, its around $40-45 a bottle, and spectacular.  I find this more elegant than the 2 shirazes above, which are incredibly rich and full bodied.  But still so good with a gourmet meal. 

$75+ wines
Yes, I am a value investor and value wine buyer.  I see people throw names about like they are the best.  But the reality is that wine doesn't have to be a cult California cab or a first growth Bordeaux wine to be in that "best" category.  Why pay $400 or $1400 for a bottle of Screaming Eagle or Le Pin when you can find wines that are also 98 points, for $100-200 bucks.  That's a lot too, but I will throw out what I like, and my opinion is that a smart value wine buyer will recognize these as the best wine can get, but for less dough.  Note that almost all of these are Cabs.

Phelps Insignia 2004 Cab - there is a reason this winery has had a bottle ranked as a #1 wine of the year by the Wine Spectator.  Sh-t its amazing, truly.  We have killed a couple of the 2004s, and they seem almost timeless.  Great now, but still possessing huge (subdued) tannins avaliable for aging for many many more years.  This one sets you back $125 or so.
Cos D Estournel 2005 Cab - $200 or so a bottle.  Yea its pricey, but compared to a Haut Lafite, or a Latour, which are First Growths, this one is half the price at the same rating.  I have yet to try any of these, we have a case in our cellar.  But at 98 points by both Robert Parker, and WS, I am willing to go out on a limb and say this is a great value, a near perfect rated wine, rated by BOTH the major wine critics.
Chateau Leoville Las Cases - another cab, as all my top category wines seem to be.  I didn't put a year on here, because it depends on what you want.  If you want the 100 point 2000 or 2005 vintage "perfect" bottles, then it will set you back $250-350.  That is really a bargain.  This is some of the best wine in the world.  I have the 2002 and 2004 vintages, some for me, some to give my kids because those were the years that they were born.  They will age long enough for them to be amazing bottles when my kids are old enough to drink em.  Normally you can find them for $100-150.  The 2007 is around $150 and rates around 95 points.  Be prepared to wait til they are 10 years old to try. 

My Favorite Winery
Clarendon Hills, ANY of their wines - I saved my favorite winery in the world for last.  I have had many bottles and tastings of a variety of Clarendon Hills wine.  The 1999 merlots were amazing, we drank 3 just a few months ago.  How many merlots last 11 years and stay in top shape?   The Brookman estate cabs from 2002 were astonishingly good.  The 1999 Liandra Syrah's were so good, I couldn't believe they only cost $40 bucks or so a bottle. 

We went to a wine tasting of the 2005 bottles last year, and I have to say that they are so powerful right now, that they were too young to drink.  These are always very very long dated, tight, age-worthy wines.  The owner of Clarendon Hills is the only guy in Australia that titles his wines as Syrahs instead of the Aussie norm of calling them Shiraz!  He is a Bordeax trained owner/wine-maker, and he makes wine to last.  His goal is to simply make the best wine in the world, period.  He eschews quick drinking fruit bombs that you see a lot in the new world, instead opting for wines that don't show their stuff for a decade.  Robert Parker puts Clarendon Hills among the top wine makers in the world, and the best in Australia.  I am very happy that this winery is almost unheard of.  Not only that but you can find bottles starting at 40-50 bucks, and on up to $160 or so for their flagship Astralis.  The Astralis is probably is as good as any wine anywhere, scoring consistently between 95 and 99 points.  We have some 2005s, but I wont be able to enjoy them til at least 2015.  At that point I'll write another blog to gloat about how good they are.  I hope!