Housing Market Bottom?? Really??

(originally published on March 25, 2008)

Technorati Tags: existing homes sales,inventory,months of supply

 

We were informed this week that sales of existing homes in the US unexpectedly rose 2.9% in February to a seasonally adjusted annual rate of 5.03 million. This was the first increase in seven months. Understandably, it caused quite a flutter among economists, with some of them, perhaps prematurely, calling for a bottom to the unending housing spiral.

But as far as economic data go, one month do not maketh a trend. Also, there is a great deal more to this data than what the headlines would suggest. The median price of single-family homes dropped 8.7 percent from February 2007, the most in four decades of record keeping by the National Association of Realtors (NAR). Although sales increased 2.9% over January’s figure, they were down a phenomenal 23.8% from February 2007.

Existing Home Sales - Seasonally Adjusted Annual Rate

 

Further, as seen in the chart above, on a seasonally adjusted annual rate, February 2008 was the weakest February since 1998. That cannot be great news.

Existing Home Sales – Not Seasonally Adjusted

 

Excluding the seasonal adjustment – on a non-seasonally adjusted basis – sales have plunged in February 2008 as compared to the prior three years. Also, it can be seen that February is one of the less important months in the calendar as far as existing home sales go, with sales generally remaining muted, before the spring selling season that begins in March.

Existing Home Sales - MoM percentage change (2004-2008)

 

Also, over the past few years, February has always been better than January. The average increase from January to February over the past four years has been 7.2%. The 2.9% gain in February 2008 is less than half of what we have seen over the past few years. Part of the reason could be that February 2008 was a leap year. Small changes in ‘Not Seasonally Adjusted’ sales (due to leap year, weather or other factors) can have a significant impact on the headline ‘Seasonally Adjusted’ numbers.

But there were a few positive data points as well. Nationwide inventory of existing homes decreased 3% in February to 4.03 million homes available for sale, representing 9.6 months of supply at the current sales pace.

Existing Home Sales - Inventory

Existing Home Sales - Months Of Supply

 

Inventories have somewhat stabilized over the past few months in the wake of a nationwide plunge in home prices. But even as inventory levels have stabilized, months of supply have risen and have remained high, as sales have plunged (months of supply = inventory/home sales rate). Typically, inventories have tended to decline in December, slowly rebounding in January and February and rising more sharply starting March as the spring selling season starts. It is thus only natural to expect inventories to reach record levels again later this year.

Chart – Inventory : Normalized seasonal pattern

(data normalized to the ending level of the previous year = 100)

 

The data over the next few months will tell us if indeed inventories are stabilizing, or if the decline in February was just noise. Either way, any contention of a bottom to the housing market is preposterous.

P.S. : Charts courtesy of Calculated Risk

 

Update :

Housing Market Bottom?? Check out the plunge in home prices in January

A Bailout By Any Other Name...

(Originally published on March 24, 2008)

Technorati Tags: moral hazard,Federal Reserve,Bear Stearns,bailout

 

The Federal Reserve’s decision last week to put up $30 billion in the form of a loan to facilitate JP Morgan’s purchase of beleaguered investment bank Bear Stearns expectedly has come under a lot of criticism. Although the criticism was probably justified, it was argued by some that this was not really a bailout, because at $2 a share Bear was essentially worth nothing. Bear had lost over 90% of its value in just a week and was down almost 99% from its $170 high marked in early 2007. Bear’s shareholders were practically wiped out and the Fed was not doing anybody any favors. But the equation now changes a bit with JP Morgan quadrupling its bid for Bear Stearns to $10 a share.

Firstly, the argument that there was no bailout of Bear Stearns is incorrect, even if its share-holders were indeed practically wiped out. Insolvency necessitates 100% wiping out of a firm’s equity. A residual value of share-holder equity – even if only $200M – essentially implies that these share-holders still fully own the firm and that they stand to benefit from any possible increases in the market value of the firm due to the significant $30 billion liquidity support provided by the Fed.

Securities firms – except the very few that could be deemed to be systemically important – should succeed or fail of their own accord, without any guarantee – explicit or otherwise – that they would receive liquidity support in the event that they end up bungling up. As a thumb rule, non-bank financial institutions that are illiquid should be allowed to fail in case they mismanage their liquidity risk and are unable to find private sources of emergency liquidity. If they are insolvent, like Bear most certainly was, they should certainly be allowed to fail.

The Fed probably contended that Bear was ‘too big to fail’ – given its size and its interconnectedness with the system, Bear’s failing posed a major systemic threat to the financial system. But any such institution that is indeed systemically too important to be allowed to fail should be brought under the Fed’s ‘lender of last resort’ umbrella only if the said institution were regulated and supervised in the same manner as banks are. Currently, US securities firms are supervised by the SEC and have much lower capital standards than banks. Bear and others are only paying for their years of excess… reckless lending practices with practically non-existent risk management practices.

Prudence suggests that securities firms should properly manage their liquidity and credit risks, with the creditors to such firms providing additional market discipline by having their claims at risk if the firm becomes insolvent. A necessary corollary to such market discipline would imply that creditors to such firms should lend funds at rates that would fully incorporate all the relevant risks – credit, market, liquidity and others – that they face.

The appropriate resolution of the Bear Stearns insolvency – that would have minimized the moral hazard argument given the Fed’s liquidity support – would have been a complete wipe out of its share-holders, an en masse firing of its entire senior management (minus the golden parachute and rich severance packages) and an eventual nationalization of the firm. Public money was used to bail out the creditors of the firm in order to prevent a systemic collapse. Instead, it should have been used to ensure an orderly disposal of its assets or operations, including inflicting appropriate losses on its creditors. It is only appropriate that creditors of insolvent – as opposed to illiquid – securities firms not be bailed out when such firms get in trouble, even if they are dubbed systemically too important to fail.

Instead the manner in which the Bear collapse was handled, the Fed and the Treasury have only ended up creating the mother of all moral hazards. Bear share-holders are far from being wiped out, the senior management has stayed in place (and probably also played a role in the offer price being quadrupled) and the firm’s creditors, who lent without considering the significant risk they were undertaking, have not experienced the losses that they would have incurred had Bear been forced to close down.

This is a bailout irrespective of what the Fed or the Treasury prefer to call it. It may help to avert a systemic crisis in the short term. But it does nothing to provide a long term solution to what is being dubbed as the biggest financial crisis since the Great Depression.

That 70's Show!

Technorati Tags: That 70's Show,inside week,pole,pennant,Philly Fed manufacturing survey,Stagflation,Recession,Catch-22

We had earlier commented that last week's trading action was suggestive of an 'inside week' formation - a consolidation after recent steep losses. This week's action was similar, with the front-line indexes staying confined within last week's trading range, forming a 'double inside week'. Inside weeks are continuation patterns, with double inside weeks being even more so. Bears have certainly taken a breather after the sharp blood-letting in January. Despite the ups and downs during the week, bulls can probably claim a semblance of victory at the end, considering multiple negative news-flow (dismal Philly Fed data, sharp rise in inflation, crude rising to over $100 a barrel), finishing the week with less half a percentage gains. Other markets, however, did much better, with Bovespa closing the week with 7% gains.

 

S&P 500 - Weekly Chart

 

The trading action from the panic January lows can be likened to that of a bearish pennant. A bearish pennant occurs because prices seldom decline in a straight line for an extended period of time. Prices will typically take brief pauses, seemingly to 'catch their breadth', before resuming their trend. The lead-in phase (the pole of the bearish pole & pennant formation) occurs as the market adjusts to unfavorable events/news-flow pushing prices sharply lower, with nervous sellers and fresh short-sellers being quite willing to sell even at lower prices. As prices drop, early sellers who had sold short at higher levels look to cover their positions even as some others start bargain-hunting. The forces are now balanced between those who are willing to support the market in anticipation of a rebound and those who believe the negative economic/fundamental developments warrant lower prices going forward. The stock begins to consolidate in a narrowing range on decreasing volume, even as the bearish news-flow and negative market sentiment persists. Things finally come to a head, when a negative news trigger comes out that leads a secondary collapse in prices through the lower line of the pennant formation. This phase (lead-out phase) is marked by a noticeable increase in volume as sellers - new and old - outnumber the bargain-hunters and the profit-takers. Prices decline sharply in this period - usually as much as the height of the pole - albeit at a slightly more gradual pace.

 

Dow Jones Industrials - Daily Chart

 

While the action over the last few weeks fits this description rather nicely, it is important to remember that patterns that everybody looks at and recognizes tend to have a high failure rate. Everybody seems to have an opinion on what this consolidation means for the market. As with any chart pattern, the challenge is not how to trade the break, but what to do once the break occurs.

Interestingly, the indexes witnessed a phenomenal rebound (as much as 250 points on the Dow Jones Industrials) in the last half hour on Friday after CNBC reported that a bailout plan for troubled bond insurer Ambac Financial could be announced next week. As had occurred on Wednesday as well, investors at times set aside existing concerns and snap up stocks either to cover bets that stocks would fall or amid genuine, if tentative, optimism that policymakers could help right the economy. Wall Street's bursts of optimism haven't proved to be long-lasting though. A government-backed plan to aid bond insurers could nevertheless help boost confidence in the bond market, where a lack of confidence has choked the flow of money.

We dissect the Philly Fed manufacturing survey this week. Manufacturing has been reasonably resilient thus far; but as the survey reveals, chinks are developing on that front as well. We will keenly watch whether the ISM Manufacturing index, that measures manufacturing activity on a national scale, comes along similar lines (slated for release on March 3). We next review the looming prospect of stagflation that has been further emboldened by this week's CPI data. It is a catch-22 situation for a Fed that is caught between two evil damaging forces. This should make for an interesting read.

Economy Continues To Slide.

 

Technorati Tags: Philly Fed manufacturing survey,recession,ISM,Empire state index

The Philadelphia Federal Reserve's general business conditions index – a widely used gauge of the health of the region's manufacturing sector – plunged to a reading of minus 24 in February, from minus 20.9 in January. Negative readings indicate a contraction in activity, while positive readings denote expansion. This was the third straight negative reading for the index and its lowest level since February 2001. The sudden slide into negative territory is reminiscent of the plunge seen in the Dec 2000 – Mar 2001 period, just before the

2001 recession.

 

 

The Philly Fed index, whose history dates back to May 1968, has proved to be a fairly reliable gauge of business cycle turning points and often – but not always – a prelude to the ISM index, the most prominent of survey-based manufacturing indicators. The Philly Fed survey, however, differs from the ISM in that it is not a composite of separate metrics of activity; if an ISM-type of weighting of the Philly Fed sub-indexes were done, it would indicate a reading of 45.9 in February from 46.6 the prior month (source: Bear Stearns Research). This, coupled with the recent Empire State Survey raise the chances that the national ISM index, which has held fort thus far, will dip below 50 for the month of February (slated for release on March 3).

S For Stagflation

Technorati Tags: inflation,joker in the pack,core CPI,crude oil,stagflation,inflationary expectations

We have pondered earlier if inflation was indeed the joker in the pack that could potentially restrain the Fed's rate-cutting spree. Certainly inflation fears did not prevent the Fed from lowering the benchmark Fed funds rate by a whopping 225 bps in just six months. But this week's data will certainly force the Fed to rethink the magnitude and pace of subsequent rate cuts.

The Bureau of Labor Statistics reported this week that seasonally adjusted consumer price index jumped up 0.4% in January and is up 4.3% over the past 12 months, near a 16-year high. This is a sharp jump from the 2% reading in August, despite the economy slowing significantly in the fourth quarter. Even after stripping out surging food and energy costs - the Fed's preferred so-called 'core' inflation – prices rose 0.3% in January, up 2.5% from the prior year, a 10-month high. This was the biggest seasonally adjusted one-month jump in core CPI in 19 months.

 

 

This should not have come as a complete surprise at all. Crude oil crossed the much-watched $100 mark this week, much to the chagrin of pundits on Wall Street. Gains in prices of industrial materials and higher prices of grains, soybeans and other soft commodities pushed the CRB index to near record highs this week. Gold surged by another $40 this week to a phenomenal $948; not to be left behind, other precious metals have seen similar jumps over the past few weeks. Bond traders had certainly seen the future early, having pushed the yield at the long end of the curve almost 50 bps over the last few weeks.

A simultaneous rise in unemployment and inflation, coupled with dwindling growth  has the market wondering whether we are headed for 'stagflation' - a period of rising inflation despite slowing or stagnant growth. Stagflation, a term coined by British Parliamentarian Iain Macleod in 1965, came to define the US economy between 1970-1981. The economy suffered three recessions in that period, with inflation soaring to 15% and unemployment rising to 9%. It took a very severe hand from the toughest of central bankers, Paul Volcker, to finally conquer inflation by dramatically raising interest rates. The monetary tightening did have its repercussions, leading to a severe recession in 1981-82.

The seeds of the 1970s stagflationary phase were actually planted in the late 1960s, when President Johnson spurred growth by the frantic spending on the Vietnam war, helped by a complying Fed which failed to sufficiently rein in that growth. Things came to a head in the early 1970s when the Arab oil embargo dramatically drove up oil prices and overall inflation levels. President Nixon, in conjunction with the then Federal Reserve Chairman, Arthur Burns tried to rein in inflation by raising rates and imposing controls on wage and price increases. However, despite pushing the economy into a severe recession in 1974-75, inflation and unemployment failed to revert back to the levels of the previous decade. Political pressure finally led to the stepping down of Burns in 1978.

 

 

Stagflation is a scary word for most economists; it is almost the sum of all fears. Having said that, as with anything that scary, fears of stagflation have actually been more common than instances of actual stagflation. The beginnings of the past two recessions (1990-91 and 2001) have typically seen a brief rise in inflation, that subsequently trended down as unemployment kept rising. The current situation, although carrying a similar title, differs significantly in its contents. Sure, the current pace of inflation is a problem. In a speech in June 2006, Bernanke indicated that core inflation, then running at 3.2% over the prior three months and 2.8% over the prior six months, was at the upper end of his tolerance level. The 3-month and 6-month core CPI now works to 3.1% and 2.7% respectively, just shy of what Bernanke had deemed to be too high. Either we have reached the limit of what the (current) Fed has been willing to tolerate in recent years, or else they have moved the bar.

It is important to note that a persistent escalation of inflation would occur only if workers and the firms that employ them come to expect the elevated inflation to persist into the future and set their wages and prices accordingly. Expected inflation is an important determinant of future inflation. If the public expects higher inflation, workers demand higher wages, prompting employers to raise the price of their goods, which results in higher actual inflation.

Fixed-income securities markets usually provide timely information about inflation expectations. The expected inflation rate - implied by the gap between the yield on 10-year nominal Treasury bonds and that on bonds whose coupons and principal are indexed to rise with CPI (TIPS) – has remained largely unchanged over the last year. Further, the median consumer expectations of price change over the next 12 months, as indicated by the University of Michigan survey, has risen modestly over the past few months but remains well short of danger territory.

 

Spread between yields on 10-year Treasuries & Treasury Inflation-Protected Securities (TIPS) of similar maturities.

 

University of Michigan consumer survey of inflationary expectations

The Fed's U-Turn

Technorati Tags: FOMC minutes,projections,Federal Reserve,recession,inflation,growth

In this context, it is also worthwhile to review the minutes of the January 30-31 meeting. We quote: “Most participants viewed the risks to their GDP projections as weighted to the downside and the associated risks to their projections of unemployment as tilted to the upside.... The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment... The potential for adverse interactions, in which weaker economic activity could lead to a worsening of financial conditions and a reduced availability of credit, which in turn could further damp economic growth, was viewed as an especially worrisome possibility.”

The Fed also revealed details of its inflation outlook, stating that “several participants pointed to the possibility that real activity could rebound less vigorously than projected, leading to more downward pressure on costs and prices than anticipated. However, participants also saw a number of upside risks to inflation. In particular, the pass-through of recent increases in energy and commodity prices as well as of past dollar depreciation to consumer prices could be greater than expected. In addition, participants recognized a risk that inflation expectations could become  firmly anchored if the current elevated rates of inflation persisted for longer than anticipated or if the recent substantial easing in monetary policy was misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation.”

That said, the Fed's recently introduced three year projections for economic growth, unemployment and inflation are worth a mention. The average Fed member is now considerably more bearish as compared to October. The Fed forecast is for 1.3-2.0% growth in 2008 and 2.1-2.7% growth in 2009, a significant drop from October estimates that called for at least 0.5% faster growth. Also, interestingly, Fed members project inflation for the year to be between 2.1-2.4% with core inflation coming in at 2.0-2.2%. This is in stark contrast to what is currently being experienced. Clearly, for inflation to meet that projection, it will have to slow significantly in the latter part of the year.

This contention is not intellectually inconsistent; recessions are generally disinflationary. The Fed remains concerned about inflation as it should. But their forecasts reflect the logical effects of a slowing economy. The minutes reveal a projection, that is as subtly bearish as would be politically and socially acceptable. A forecast that anticipates an outright recession or a persistently high inflation or a 6% unemployment rate would cause panic on the Street and a loud call for the Fed chief's head. Having said that, missing a recession entirely would cause people to lose confidence in their projections entirely. It will be interesting to see how the forecasts change over time as the new data gets factored into the projections. We believe that the forecasts, at least the GDP projections, still remain fairly optimistic in light of recent data releases.

Catch-22 For The Fed

Technorati Tags: Catch-22,Federal Reserve,stagflation,interest rate cut

The latest frenzy over the multiple, repeated sightings of the dreaded stagflation enemy is perfect fodder for the media. Fear is the primary staple of financial journalism. Expect to see a lot more debate on stagflation in the coming days. Our take on this is fairly simple: the booming period of growth, in any meaningful sense of the term, is over. Whether we are technically in a recession or merely on the cusp of one is immaterial; there is growth only in isolated sectors and pockets of the economy. Further, there are compelling reasons to believe that a contraction this time around would be more severe and more protracted than the previous two recessions. The significant slump in demand should prove to be a sufficient douse to the inflationary fire. The peeling of the sub-prime onion has led to a collapse in residential real estate prices, on a scale not witnessed since the 1930s, a remarkable unraveling of the dangerously over-leveraged and reckless - yet all-important - banking system and a dramatic increase in household insolvency.  This has created an economic Lernaean hydra, not seen since the Great Depression.

Having said that, it is important to appreciate the risks as they are. A persistently weak dollar (the dollar has lost 37% of its value in the past five years) raises the price of all dollar-denominated commodities, such as oil and other raw materials, as well as imported goods. Even if consumption of products falls in the United States, resilient demand from emerging markets such as China and India could cause prices of many goods to remain persistently high. Counter-intuitively, the only malaise for a stagflationary scenario is a significant recession in the US that also takes down global growth with it.

The Fed is in a Catch-22 situation, caught between a possible stagflationary environment versus the serious risk of a general deflationary collapse and onset of a protracted, depression-like economy. The Fed now knows which is the greater of the two evils. A 125 bps rate cut in January signaled beyond doubt where the Fed's concerns lie. The sharp plunge in economic indicators over the last few weeks is consistent with an economy that is rapidly spiraling towards a recession. An expected slowdown which requires monetary easing of that magnitude will surely pull demand down with it.

We believe the Fed will cut rates at least another 25 bps at its March 18 meeting (and quite possibly 50 if we get another dreadful unemployment report) We would not be surprised to see the target Fed funds rate at 2% by the middle of the year. But, having said that, there will certainly be more reluctance to follow the easing path here on.