State of U.S. Housing
(October 30, 2011)
Dear Subscribers and Readers,
Let's 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.
With the election year coming up, the U.S. Administration is now finding ways to strengthen the U.S. housing market. For example, the Administration recently revised the Home Affordable Refinance Program that would make it easier for some borrowers to refinance their mortgages. More important (in the immediate sense), the Administration is planning to convert the large inventory held by the GSEs into rentals—thus taking a significant chuck of the housing glut off the market (note the GSEs' policies have always been pro-cyclical). Finally, parts of the FOMC have remarked about the possibility of more Agency MBS purchases with the intent of further pressing mortgage yields.
This is not surprising, as residential investment has declined to just 2.2% of GDP, versus 6.3% as the peak of the boom. Moreover, U.S. housing has historically had a disproportionately high impact on GDP growth, through wealth effects (although the accompanying empirical evidence varies widely), the propensity of mortgage equity withdrawals, and consumer and business confidence. Specifically, Goldman Sachs estimates a 2% to 8% wealth effect on GDP growth. In other words, for every 3% appreciation in U.S. housing prices (approximately $500 billion increase of net worth), consumer spending would increase by $10 to $40 billion (translating to 0.1% to 0.4% of consumer spending growth).
Interestingly, housing turnover also has a significant effect, as a Department of HUD study suggests that a new homebuyer typically spends an additional $5,000 in the first year; while an existing homebuyer spends an additional $3,700. In addition, housing construction is relatively labor intensive, with total employment in construction being higher than construction's share in GDP. Finally, wages in the construction industry are 20% to 25% than average U.S. wages—thus providing a powerful intermediate effect.
The various censuses and surveys suggest an estimated vacant housing unit of 15 to 19 million units this year, up from 10 to 14 million units in 2000. Combined with the fact that nearly 10 million mortgages are over 60 days delinquent, it is not a surprise to see the ongoing decline in U.S. housing prices (see below chart courtesy of Goldman Sachs and CoreLogic):
Not surprisingly, U.S. housing starts have remained at depressed levels (following chart again courtesy of Goldman Sachs):
Both the empirical and anecdotal evidence suggests that U.S. housing disproportionately large effect on U.S. GDP growth. Goldman Sachs estimates that U.S. residential investment, through various multiplier effects, actually had a negative impact on GDP growth last year (subtracting 0.15% of total GDP growth), while in normal times, the total housing effect would be an additional 0.5% of GDP growth, and in boom times, more than 1.25%.
Both demographics and estimated income growth suggest that housing inventories won't be fully absorbed until at least late 2013. While the Administration and the Federal Reserve have flexibility in strengthening the housing market, I do not see any meaningful appreciation until 2013 (although homebuilders could be a buy sometime next year). Once the U.S. housing market stabilizes, however, then U.S. monetary policy would have to be renormalized relatively quickly.
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 in the following chart from July 2008 to the present:
For the week ending October 28, 2011, the Dow Industrials rose 422.32 points, while the Dow Transports rose 198.15 points. Over the last five weeks, the Dow Industrials has risen a whopping 1,459.63 points (13.4%), and the Dow Transports 793.21 points (18.9%). Despite stronger-than-expected earnings and the prior oversold conditions five weeks ago, this rally has come too far, too fast. We did not foresee such a tremendous rally, especially since no sustainable solutions to the European Sovereign Debt Crisis have yet arisen from the latest EU Summit. Since our liquidity indicators and technical indicators remain weak, we anticipate a correction over the next several weeks. We believe the Dow Industrials will likely revisit the sub-11,000 level. We will likely initiate a 50% long position should the Dow Industrials fall below 11,000.
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 -7.9% to -4.0% for the week ending October 28, 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 2001 to the present:
The four-week MA bounced from a severely oversold level over the last three weeks, but remains near its lows during last summer's correction. Moreover, the ten-week MA (not shown) declined to a new low a couple of weeks ago, hitting its most oversold level since early September last year. As such, we may initiate a 50% long position in our DJIA Timing System, but only should the Dow Industrials fall below the 11,000 level again.
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. 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:
Both the 20 DMA and the 50 DMA increased last week. Most likely, both the 20 DMA and the 50 DMA have reversed from their historically oversold levels three weeks ago. In general, a reversal from a historically oversold level has significant bullish implications from a sentiment standpoint. Coupled with bullish confirmations from our other sentiment indicators, my sense is that the U.S. stock market has already hit its lows in early October. However, given the significant volatility, we will refrain from initiating a 50% long position until the Dow Industrials decline to 11,000 or below.
Conclusion: The U.S. housing market remains in a rut, driven by lack of income growth, negative housing equity, mortgage delinquencies, an ongoing housing glut, and the lack of access to mortgage borrowing. Given the substantial multiplier effect, it is thus not surprising for the Administration to implement policies to strengthen U.S. housing through the elimination of the glut and providing refinancing opportunities for homeowners. As mentioned, both demographics and estimated income growth suggest that housing inventories won't be fully absorbed until at least late 2013. While the Administration and the Federal Reserve have flexibility in strengthening the housing market, I do not see any meaningful appreciation until 2013 (although homebuilders could be a buy next year). As for the U.S. stock market, we remain neutral in our DJIA Timing System; but may initiate a 50% long position should the Dow Industrials fall below the 11,000 level. Subscribers please stay tuned.
Henry To, CFA, CAIA