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An Update on the REIT Market

(February 28, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 9 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 1,846.74 points as of yesterday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,537.74 points as of yesterday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.

In our first commentary on REITs just slightly over three years ago (“REIT Market Overheating?” published February 1, 2007), we warned subscribers that REIT valuations were getting very overstretched, and while general liquidity remained ample, subscribers should be very cautious about investing in REITs as “it probably will not take much for anything to act as a catalyst for a major peak in the REIT market.”  Coincidentally, the bull market in U.S. REITS actually peaked within a few days of the publication of our commentary. REIT prices would not bottom out until March 2009, as shown in the following chart courtesy of NAREIT:

Major Stock Total Return Indexes

From the end of March 2009 to January 2010, the NAREIT Equity Index rallied nearly 80%, despite ongoing issues in the commercial real estate market, including the relative lack of liquidity (the CMBS market is nowhere close to recovering), forced deleveraging by real estate lenders, and the clouded outlook for earnings (earnings for REITS are expected to continue its decline for the foreseeable future).  In addition, there has been a substantial rise in troubled loans in the $700 billion CMBS market – with the amount of troubled loans rising from $1.4 billion a month in 1Q 2009 to $2.7 billion a month in 4Q 2009.  According to Credit Suisse, the amount of troubled loans in the CMBS market is projected to rise further – to as much as $60 billion for 2010, or an average of $5 billion a month going forward (note that this number is easily measurable/projected since troubled loans tend to show up in delinquency numbers first).

So where does that leave us?  Thankfully, liquidity in both the CMBS and the REIT markets has improved in recent months.  For example, as shown in the below chart, 10-year CMBS AAA spreads have declined dramatically since March 2009, to just 441 basis points as of February 24, 2010.  5-year CMBS AAA spreads (not shown) have declined to just 202 basis points.

CMBS Spreads

In other words – as long as the CMBS product is underwritten conservatively and investors are protected in various ways (thus helping the product garner a AAA rating) – deals can still be done (on the other hand, 10-year AA CMBS spreads are still at nearly 3,000 basis points!).  On a YTD basis, there have been $2.2 billion of U.S. CMBS originations, compared to $3.0 billion for the whole of 2009 ($400 million of which was TALF-assisted)!  More encouragingly, three recent new-issue CMBS deals were priced at spreads well below those of secondary trading, largely because the new products were underwritten very conservatively (as shown in the following chart, courtesy of Prudential Real Estate Investors – note that the following title should read “Sept. 2008 to Jan. 2010”):

Spreads of Secondary-Market CMBS, Sept. 2008 to Jan. 2009, and Three Recent Deals

Within the U.S. REIT market, liquidity has also returned.  In fact, liquidity in the U.S. REIT market is nearly back at its late 2006/early 2007 peak, as U.S. REITs spent most of last year trying to raise much-needed capital (the trailing 12-month total of REIT capital offerings is nearly $40 billion):

REITs Spent Much of 2009 Deleveraging and Repairing Balance Sheets

Make no mistake: There is a tremendous amount of liquidity sitting on the sidelines – still waiting for opportunities in the CMBS distressed loans market, as well as in actual real estate properties.  With the outlook for commercial real estate still clouded, this “money on the sidelines” (which includes longer-term private equity funds as well as hedge funds) will probably stay on the sidelines for a little while longer.  In addition, investors who are looking to invest in REITs are also taking a “wait and see approach,” as REITs' dividend yields have come down substantially since peaking in March 2009.  As shown on the following chart, the spread between the equity REIT dividend yield and the 10-year Treasury yield has come down dramatically – from as high as 7% in March 2009 to just 0.51% as of month-end January 2010:

Monthly Equity REIT Dividend Yield Spread

Sure, the dividend payout ratio for REITs is at a historical low of 64% (compared to the long-term average of 73%), but even an adjustment of this lower dividend payout ratio to 73% would only bring the spread to just 1% or so.  With the commercial real estate earnings outlook still clouded, and with many properties still in distress and deleveraging, now is not the time to invest in REITs just yet.  Despite the clouded outlook, however, I believe REIT prices hit bottom in March of last year.  Finally, any substantial correction in REIT prices over the next 6 months (especially any decline that would cause the yield spread to spike up to 2% or more) could be a good buying opportunity, given the tremendous amount of investor liquidity sitting on the sidelines waiting for better commercial real estate/CMBS prices.  We will continue to monitor the U.S. commercial real estate sector for our subscribers closely for the rest of this year.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2007 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2007 to February 26, 2010) - For the week ending February 26, 2010, the Dow Industrials declined 77.09 points, while the Dow Transports rose 74.05 points. Given the short-term overbought condition of the market - as well as the jitters surrounding Greece - last week's consolidation is perfectly understandable. The market will most likely remain jittery in the next couple of weeks as the Greek fiscal situation comes to a showdown (the Greek government intends to do a bond issue over the next couple of weeks). However, while the troubles in Greece, Portgual, Spain, Dubai, and the U.S. commercial real estate market will continue to cast a deflationary cloud on the global markets, my sense is that the major effects would be limited to commodities and certain cyclical sectors, especially if China continues to tighten its monetary policy. Most importantly, given the decent momentum and decent valuations in the U.S. stock market - the cyclical bull trend that began in early March remains intact. For now, we will maintain our 100% long position in our DJIA Timing System.

For the week ending February 26, 2010, the Dow Industrials declined 77.09 points, while the Dow Transports rose 74.05 points.  Given the short-term overbought condition in the stock market, last week's small correction in the Dow Industrials was not a surprise.  Moreover, the Dow Transports actually managed a good-sized gain.  With the Greek fiscal crisis still in flux, I continue to expect global equity markets to consolidate – and could possibly be stuck in a range until late March or even early April.  However, given the strong momentum from the early March 2009 lows – and combined with decent valuations, strong liquidity, and strong upside breadth – there is no question that the cyclical bull market is intact.  We will maintain our 100% long position in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators finally rose last week (after experiencing a dramatic three-week decline) - from a reading of 4.9% to 5.1% for the week ending February 26, 2010.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending February 26 2010, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of 4.9% to 5.1% - taking a break from its immense decline over the prior three weeks. As a result, this reading is no longer overbought, although my sense is that the stock market will consolidate further before it can experience another sustainable move upwards. For now, we will maintain our 100% long position in our DJIA Timing System.

After hitting a 26-month high four weeks ago, the four-week MA of the combined Bulls-Bears% Differential ratio has literally dived – and, despite last week's bounce - is still near its most oversold level since August of last year.  While this reading is no longer oversold, I still don't expect the market to just take off from here.  My best guess is that the market is still stuck in a consolidation phase (it takes time to work off the bullish sentiment) – one that could extend to March or even April.   However, given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally starting in late spring and summer of 2010, and probability suggests that we will end 2010 with a new cyclical bull market high.  For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March 2009 remains intact.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After touching a fresh 6-month high of 137.6 on December 1st, the 20 DMA consolidated and subsequently reversed course dramatically - declining to just 105.9 the Friday before last - its lowest level since late November 2008. It is no longer overbought relative to its readings over the last two years. Moreover, the 50 DMA has also *caught up* - declining to just 118.0 last Friday - its lowest level since early January 2009. In addition, all our other sentiment indicators have gotten much less bullish over the last few weeks- suggesting that the market should be okay for the foreseeable future. For now, we will remain 100% long in our DJIA Timing System.

For the week ending February 26, 2010, the 20 DMA rose from 105.9 to 107.4.  Despite last week's bounce, it is still near its most oversold level since late November 2008.  Moreover, with last week's decline, the 50 DMA has also entered oversold territory.  However, I continue to expect the market to consolidate over the next few weeks, especially the ongoing troubles of Spain, Greece, Dubai, and the European banking system.

Conclusion: While the U.S. REIT market likely bottomed during March of last year, current valuations of U.S. REITs are still too high for investors, especially given the clouded earnings outlook of the U.S. commercial real estate market and ongoing liquidity issues in the CMBS market.  Moreover, while there is a tremendous amount of investor interest in distressed CMBS loans and actual real estate properties, many of these investors are taking a “wait and see” approach.  Most likely, much of these funds won't be invested into the markets unless valuations come down again.  With many properties still in distressed mode, and with the U.S. retail and office market still depressed, we also advocate a “wait and see” approach for our subscribers.

As for the stock market, it is still likely mired in a consolidation phase.  While I don't believe a Greek default is probable, the market should remain jittery unless or until something concrete is done about the dismal fiscal situation in Greece.  Given the rigidity of its financial system and the lack of its central bank to devalue and print money, it will be difficult for Greece to resolve its current situation without an EU or IMF-led bailout.  Given the overbought conditions coming into the correction and the lack of a serious correction since early March of last year, probability suggests that the correction will be deeper and last longer than all prior corrections since March of last year.  There is strong support for the Dow Industrials in the 9,500 to 9,800 range.  However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market – and thus we remain 100% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA


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