Timing the US Housing Recovery
(February 19, 2012)
Dear Subscribers and Readers,
In our October 30, 2011 commentary (“State of U.S. Housing”), we mentioned that US housing—including the residential construction and home improvement industries—have had a disproportionately high impact on historical US GDP growth. This is not a surprise, given that US home ownership steadily increased after World War II, along with the rising popularity of second mortgages or home equity loans in the years leading up to the peak of the US housing bubble. Our projection at the time was that US housing won't recover until late 2013 at the earliest—at which point US monetary policy would have to be renormalized relatively quickly, as an improving US housing market, combined with the maturity of the current deleveraging process, will likely lead to significant GDP growth and inflation unless the Fed Funds rate was raised and the Fed's balance sheet renormalized.
Looking at the evidence, including the recent jump in US job growth and assuming the US manufacturing industry experiences a “Renaissance,” we remain convinced that late 2013 remains a reasonable timeframe for the beginning of a rebound in US housing. Goldman estimates excess inventory at 2.5 million homes. Just as important, household formation has remain depressed—falling from a historical average of 1 to 1.3 million units a year, to just 600,000 to 700,000 a year from 2008 to 2011 (following chart courtesy Goldman Sachs):
Aside from housing affordability (which includes housing prices, mortgage rates, and the availability of mortgage loans), household formation—and subsequently, home purchases—is also dependent/(positively) correlated with marriage rates, education levels, the employment-to-population ratio, and the ongoing trend of housing prices (rising house prices lead to higher household formations as people buy in anticipation of higher prices). With US housing prices now stabilizing, the last factor is no longer a concern, while the recent job growth numbers (which also directly impact marriage rates, as people without jobs don't tend to get married) suggest that the employment-to-population ratio will improve in 2012 and 2013. With a natural population growth rate of 0.9% (births minus deaths plus immigration), this bodes well for housing formation in 2012 and 2013. Goldman specifically forecasts household formation to improve to 800,000 units in 2012, and 1.1 million in 2013 (below chart courtesy of Goldman Sachs).
Assuming an excess inventory of 2.5 million homes, Goldman asserts clearing the entire inventory will take over three years. However, please keep in mind that Goldman has not taken into account the recent (surprising for some) job growth in their official GDP/unemployment forecasts. In addition, Goldman's official forecasts do not take into account “exogenous shocks” (either positive or negative) such as the US manufacturing Renaissance which we discussed in last weekend's commentary, and which is happening as we speak. I expect US household formation this year to surpass Goldman's expectations—to over 900,000 units, and over 1.2 million units next year as “pent-up” demand from the last several years catches up to the structural trend. Finally, US housing is now undervalued compared to most of the world's major countries (with the glaring exception of German housing prices)—making US houses an attraction option for Chinese, Middle Eastern buyers, etc. By late 2013, I expect the US housing median price to resume its long-term structural uptrend.
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 February 17, 2012, the Dow Industrials rose 148.64 points, while the Dow Transports declined 14.62 points. The lack of a confirmation of the new high DJIA highs by the Dow Transports is a cause for concern, at least in the short-run. In fact, we are looking for the correction to continue over the next several weeks. That said, with the Fed committed to an extremely dovish policy (near-zero Fed Funds until 2014; and potential QE3 later this year), the latest cut in the required reserves ratios in the Chinese banking system, and the latest (surprised) easing by the Bank of Japan, the Dow Industrials should surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks but since we are dissolving MarketThoughts.at the end of this month, we will not make any more moves 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 four-week moving average of these sentiment indicators increased from 23.9% to 24.9% for the week ending February 17, 2012. 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:
Since hitting a multi-year low of -11.3% in early October, the four-week MA has spiked by a whopping 36.2%. The four-week MA is now at its most overbought level since late February 2011. As such, we would not be surprised if the market beings a correction over the next several weeks. That said, with the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines, a dovish Fed, the resilience of the US economy, and Chinese and Japanese easing—we continue to look for a rally in US stocks and US financial stocks over the next several months.
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 is such 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:
Ever since breaking 100 in mid-December, the 20 DMA had consistently risen until four weeks ago. Over the last four weeks, however, the 20 DMA finally corrected, declining from 123.9 to 97.1. In fact, it is now significantly lower than its 50 DMA. This pullback was much needed as this indicator was getting very overbought in the short-run. That said, our other sentiment indicators remain overbought on a short-term basis—hence, we believe the market is highly vulnerable to a correction over the next few weeks. Over the next several months, though, we remain bullish on US stocks and US financial stocks.
Conclusion: A major pillar of the US economy—US housing—should provide a significant tailwind for US GDP growth by late 2013, given depressed housing prices, a mature general deleveraging process, record low mortgage rates, improved bank lending, a recovering job market, a Renaissance in US manufacturing, and increasing demand from foreign investors. We expect US household formation to surpass 900,000 units this year, and over 1.2 million units in 2013. By late 2013, the Fed will need to normalize the Fed Funds rate, as well as start selling Treasuries and GSE mortgage-backed securities as part of a plan to rein in excess liquidity. Assuming that US solar technology has not reached “grid parity” by the end of 2013, commodity price inflation (not to mention wage inflation) could be a significant concern by that time. In the short-run, we continue to believe that US GDP growth will surpass 3% this year, especially given the recent easing by the Bank of Japan and a 50 bps decrease in the required reserves ratio by the People's Bank of China.
Henry To, CFA, CAIA