Profit from the Housing Mess with ETFs

Housing Prices to Fall Further

According to a recent Newsmax article, Gary Shilling forecasts that US home prices will fall a further 20% or more in 2009 which is even more pessimistic than the 15% forecast by the renowned Yale economist, Robert Shiller.

Home prices have already dropped 25% as shown by the S&P Case-Shiller index. Shilling cites the cause of this further drop down to basic economics of supply and demand. There is simply an oversupply of inventory and not enough demand to meet this supply. It doesn’t help that speculators have left in droves and there is a doubling of foreclosures and potential buyers are waiting on the sidelines for housing prices to fall further.

The current 1.5 million homes in inventory represent about 1 year’s supply over the long term and there is just not enough creditworthy buyers out there to buy these up. The US Federal Reserve has been frantically buying up billions in mortgage backed paper to drive down interest rates from the already low 5.1%; however, due to falling house prices, any rate below 5% actually represent around 26%.

The negative overtones of these forecasts were confirmed recently by NYU economist Nouriel Roubini when he told Bloomberg that housing starts and building permits were in a free fall and that there was no bottom in sight within the foreseeable future.

We are in a Bear Market

There is no denying that the stock market is in a bear market and that the real economy will not see a recovery until 2010 according to some analysts. Some economists including Gary Shilling have cited the dreaded “d” word, depression, and if the last depression during the 1930s is anything to go by, the stock market still has another 30-40% to fall. Yes the past is not a good indicator for the future and although each recession is different to the others, and this depression will be different to the previous depression, the velocity of the fall in stock market seems to be similar.

In the last depression within the first year, the Dow Jones Industrial Index fell by around 50%, this time around, the Dow Jones Industrial Index fell from a peak of around 14000 in October 2007 to around 7500-8000 in October 2008 which represents a fall of more than 40% (see chart below).

In the last depression, the Dow Jones Industrial Index fell by 89% from 1929 to 1932, so it wouldn’t be surprising if this time around the Dow Jones Industrial Index fall a further 40-50% over the next two years. This would confirm the views of economists such as Gary Shilling who are foreseeing the depression to continue until 2010.

The Housing Market Index

A proxy for the US Housing Market is given by the iShares Dow Jones US Real Estate ETF with ticker code IYR.

FUND SUMMARY

The investment seeks investment results that correspond generally to the price and yield performance of the Dow Jones U.S. Real Estate Index. The fund generally invests at least 90% of assets in securities of the underlying index and depositary receipts representing securities of the underlying index. It may invest the remainder of assets in securities not included in its underlying index but which BGFA believes will help the fund track underlying index, and in futures contracts, options on futures contracts, options and swaps as well as cash and cash equivalents, including shares of money market funds advised by BGFA. It is nondiversified.

FUND OVERVIEW

Category:	Specialty-Real Estate
Fund Family:	iShares Trust
Net Assets:	1.53B
Yield:	9.88%
Fund Inception Date:	12-Jun-00
Legal Type:	Exchange Traded Fund

FUND OPERATIONS

IYR Category Avg. Total Expense Ratio 0.48% N/A Annual Holdings Turnover 7% 13.91 Total Net Assets 1.53B 418.67M

TOP 10 HOLDINGS ( 43.61% OF TOTAL ASSETS)

Company Symbol % Assets ANNALY CAPITAL MANAG NLY 4.88 AVALONBAY CMTYS AVB 2.66 BOSTON PPTYS INC BXP 3.75 EQUITY RESIDENTAL EQR 4.62 HCP, INC. HCP 4.02 PLUM CREEK TIM REIT PCL 3.32 PUBLIC STG PSA 5.85 SIMON PPTY GRP INC SPG 6.79 VENTAS INC VTR 2.75 VORNADO REALTY TRUST VNO 4.97

EQUITY HOLDINGS

Ratio IYR Average Price/Earnings 17.23 Average Price/Book 1.19 Average Price/Sales 2.09 Average Price/Cashflow 7.56

SECTOR WEIGHTINGS (%)

Sector IYR Software 0 Industrial Materials 4.73 Energy 0 Utilities 0 Hardware 0 Media 0 Telecommunication 0 Healthcare 0 Consumer Services 0 Business Services 0 Financial Services 95.11 Consumer Goods 0

As you can see, shockingly, the weighting of this real estate ETF is heavily in financial services (95%) and that in this bear market environment, having an average price to earnings ratio of 17.23 is way too high. At this PE ratio, even if prices were held constant, the earnings would be expected to fall further which means that at current prices, the PE ratio would actually become larger since the P would be divided by a smaller number (falling earnings), which means that along with falling earnings, prices would have to fall further to maintain the same PE at 17.23 or to lower the PE to say 15 or lower. I have calculated that at an average PE of 17.23, assuming earnings would fall another 20% this year, for the PE ratio to fall to a more reasonable 15, prices would have to come down by a further 30%!

So it is not surprising that this ETF has a year to date performance of -40% (see the chart of IYR below)!

PERFORMANCE OVERVIEW

Year to Date Return (Mkt): -39.85% 1-Year Total Return (Mkt): -39.85% 3-Year Total Return (Mkt): -12.69%

How to Profit from All This!

One way to profit from this is with a contra or inverse ETF with ticker code SRS.

FUND SUMMARY

The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Real Estate index. The fund normally invests 80% of assets in financial instruments with economic characteristics that should be inverse to those of the index. It may employ leveraged investment techniques in seeking its investment objective. The fund is nondiversified.

FUND OVERVIEW

Category: Bear Market Fund Family: ProShares Trust Net Assets: 1.05B Yield: 1.45% Fund Inception Date: 30-Jan-07 Legal Type: Exchange Traded Fund

However, there is a risk attached to buying inverse funds since it is leveraged on a daily basis and it moves at twice the daily move of the Dow Jones Real Estate Index. Thus moves in this index is magnified. Hence it is not really a fund to hold onto for more than 3 months at a time.

However, due to the weak fundamentals of the US real economy, its corporations and the housing and financial sectors, I believe that from current levels, SRS could move a little further down, but there will definitely be a change in trend to the upside lasting 2-3 months from here onwards. I believe SRS could go up to 100 or higher in the next round of falls in the overall sharemarket.

Please see the chart below of SRS:

As you can see, SRS is now edging closer to the 50 day moving average, and the MACD is above its trigger and edging closer to the threshold of 0 and the slow stochastic is also above its trigger, so although in the short run it could fall back to its support of 50, I believe that it could run up to 100 or higher in the next bearish phase of the overall stock market. So if you believe in the weakness of the housing market and global economy, and up for some risk, why not buy SRS?

Reference: http://finance.yahoo.com

Disclaimer: This is general information only. Consider seeking professional advice before proceeding to make an investment decision.

Disclosure: The author has at present no position in IYR or SRS, although would like to accumulate SRS soon.

Comments

[townncountry:]

Interesting article. Compelling reasoning.

Feb 15 09:11 AM

[CLH:]

SRS certainly has'nt been a good investment over the last year even though real estate has continued to go down. The next rally in SDS may go to 100 but would be impossible to time. For a long term investment IYR certainly makes more sense. I do agree with you that the present market correction may last for 2 or more years.

Feb 15 09:59 AM

[Kacey:]

This is commercial real estate. This is not residential real estate. Schiller's index does not focus on commercial real estate at all.

Feb 15 12:02 PM

[Alan Young:]

Agree with Kacey. The securities represented in IYR and SRS are not represented by Schiller. They may have similar or parallel dynamics, but it would require a separate study to have a statistical analysis that might be useful.

Feb 15 12:14 PM

[thatguy57z:]

There is no light at the end of this tunnel, for along time the wrist is yet to come where headed for the big D,fare bigger then the 30's, no one has any money to spend so hang on to what and you also should take it out of your bank and put it some where you know its safe from the government.

Feb 15 12:20 PM

[thatguy57z:]

By the way check the website out

Feb 15 12:22 PM

[Urbane Gori...:]

Commercial real estate would appear to be just beginning it's slide, unlike residential, which is presumably closer to bottoming.

Feb 15 03:56 PM

[omooc:]

SRS dropped over 70 points one day several weeks ago (from the chart above, it seems to be in late Dec 08). Any reasons for this large percentage drop?

Feb 15 07:34 PM

[Rob Viglione:]

Shorting IYR is likely a good bet right now, but just remember you are shorting commercial real estate. If you want to go after housing, consider shorting housing index futures. These are available for several large cities.

Personally, I think it prudent to target commercial real estate right now. Valuations, as stated by the author, are too high given the market environment and likely contraction of rental growth rates, increasing vacancies with business deterioration (esp. for office and retail), and financing issues.

Feb 15 08:46 PM

[Kunst:]

There may have been a distribution. That's another wild card with this very problemsome ETF.


On Feb 15 07:34 PM omooc wrote:

> SRS dropped over 70 points one day several weeks ago (from the chart
> above, it seems to be in late Dec 08). Any reasons for this large
> percentage drop?

Feb 15 11:25 PM

[donzelion:]

I'd look to the Japanese experience, and anticipate the same in the U.S. - not a "Depression" a la the 30s, but an extremely deep, persistent recession. And much like Japan, the cause is the collapse of a bubble + the change in demographics - no matter what credit vehicles are available, few people in their 50s - folks with the best credit - will buy a new home when the environment is risky. Makes little difference whether such people are Japanese or Americans .

One piece of today's decline comes from recognition that many of the baby boomers who purchased houses post-2001 were following a "Rich Dad, Poor Dad" line of reasoning - the house is an investment when one intends to sell it, and a liability when one intends to live in it. The "house flippers" busily flipped their houses to one another, enriching banks, certain chain stores, and a lot of illegal contractors, but they added very little to the U.S. economy and squandered much of their own nest egg.

Feb 16 05:09 AM

[Rocknbob:]

Nice article...... I a m long SRS and have a small profit take point of 89. I appreciate the study of the stochastics , which, combined with the commercial RE environment BEGINNING to deteriorate, could mean a roar from these levels to 100... My only hope in an economy such as this...

Feb 16 06:34 PM