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Commercial Real Estate Still Deleveraging

(January 23, 2011)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 13 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;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

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;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

In our first commentary on the commercial real estate market and REITs four 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:

From the end of March 2009 to November 2010, the NAREIT Equity Index rallied nearly 130%, despite ongoing issues in the commercial real estate market, including depressed bank lending, the lack of CMBS origination, and forced deleveraging by real estate lenders, and substantial REIT equity issuance.  Going forward, however, the outlook for the pricing of REITs and commercial real estate is more clouded, as REIT valuations are now at relatively high levels.  The following chart (courtesy of NAREIT) shows that the spread between REIT dividend yield and the 10-year Treasury yield is right at its 20-year average:

The current yield spread is up from an almost zero yield spread earlier last year—and eventually, REITs (and commercial real estate) will recover as economic growth accelerates later this year and in 2012 (our view).  In the meantime, commercial real estate debt (bank lending, CMBS, etc.) remains in deleveraging mode.  For example, the U.S. CMBS market remains very depressed.  Since its peak in 1Q 2009, total CMBS outstanding is down 18.5% ($118.7 billion) to $640 billion (as of 3Q 2010).  More important, CMBS issuance is still effectively non-existent—on a YTD basis, CMBS issuance is zero.  Commercial mortgages held by banks (which make up 51% of the market) is down 8.5% ($136.1 billion) from the peak, to $1.6 trillion outstanding.  The following exhibit (courtesy of Prudential Real Estate) shows the outstanding commercial mortgage holdings by type in the U.S. as of 3Q 2010:

Based on the historic experience of deleveraging in the U.S. commercial real estate sector, and based on decent economic growth in 2011 and 2012 (we believe U.S. economic growth would surprise on the upside), Prudential believes that the absolute deleveraging in the U.S. commercial real estate sector will cease by the end of 2011.  As a percentage of total credit market debt, however, U.S. commercial real estate debt will remain depressed.  More important, Prudential does not believe commercial mortgage debt outstanding will surpass its 1Q 2009 peak until 2016.  Based on our estimates, however, we believe this may be a little pessimistic.  Sure, it's a very long-term timeframe—but we see U.S. commercial real estate debt outstanding regaining its former peak sometime in 2014 or 2015—based on upside surprise in U.S. GDP growth (and ongoing low interest rates).  In the meantime, the deleveraging in the U.S. commercial real estate market isn't over—and given the run-up and the relatively high valuations in REITs, we advocate a lower-than-normal allocation to U.S. REITs.

Let us now discuss the most recent action in the U.S. stock market using 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 2008 to the present:

For the week ending January 21, 2011, the Dow Industrials rose 84.46 points, while the Dow Transports declined a whopping 182.68 points.  The non-confirmation of the Dow Industrials by the Dow Transports is one of the most flagrant divergences in the Dow indices (per the Dow Theory) since the beginning of this cyclical bull market.  Combined with the overbought market, challenging global liquidity environment, the ongoing troubles in the European Monetary Union and the stubborn increase in U.S. municipal bond yields, I expect an imminent correction in the stock market. We remain completely neutral in our DJIA Timing System, although the cyclical bull market that began in early March 2009 remains intact.

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 four-week moving average of these sentiment indicators increased from a reading of 30.2% to 30.8% for the week ending January 21, 2011.  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 1998 to the present week:

Note that the four-week MA increased for the eighth consecutive week from a reading of 30.2% to 30.8%—and has pierced above its October 2007 highs to its most overbought level since late February 2007 (right before a >500-point weekly decline in the Dow Industrials).  In addition, the ten-week MA (not shown) rose for the 20th consecutive week to 26.0%, and is at its highest level since early March 2007.  By any measure, both the stock market and investors' sentiment is now highly overbought.  Combined with our bearish liquidity indicators, I expect the U.S. stock market to experience a correction soon.  We will retain our neutral position in our DJIA Timing System.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  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:

The 20 DMA declined from 135.9 to 132.9 last week, while the 50 DMA decreased from 136.3 to 135.2.  Note that the 20 DMA is now below the 50 DMA—and both are in a downtrend.   All else equal, this sentiment indicator (and the market) is now in a downtrend. Meanwhile, the ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak in late December, the 20 DMA rose to its highest level since mid-July 2007.  With both the 20 DMA and 50 DMA at highly overbought levels (relative to their readings over the last three years), and combined with the bullishness in our other sentiment indicators, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe a market correction is imminent.

Conclusion: With REITs (and commercial real estate) having rallied nearly 130% since their lows in March 2009, it is time for this asset class to take a breather.  More important, commercial mortgage origination remains low—and probability suggests that more deleveraging is to come over the course of 2011.  I expect 2011 to be a “transition year” for REITs and commercial real estate, despite the fact that we're looking for 3% to 4% real GDP growth this year.  In addition, the U.S. stock market remains highly overbought.  Combined with extremely bullish sentiment, challenging liquidity, and a slightly overvalued market, we are short-term bearish on the U.S. stock market.  We remain neutral in our DJIA Timing System and will remain so until the market becomes oversold.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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