Thoughts on REITS, Financials and the U.S. Dollar

A good thread busted out in the comments on Thursday's post. A reader asked me to weigh in on my concerns about inflation (hyper or otherwise) and the status of the dollar. Another reader asked for my take on financial stocks and REITs.

So let's roll 'em up and dive in.

The current event has been surprising to me in its magnitude. The things I relied on to be underweight financials (the sector's weighting in the SPX and the inversion of the yield curve) warn of problems but they don't say anything about magnitude. Simply heeding those warnings means not having to be correct about magnitude. I only held one REIT across the board, Equity Residential (EQR), which I sold in late 2007. Other trades in the sector included a swap out of Barclays (BCS) and into Santander de Chile (SAN) in December 2007 and then I bought Chicago Mercantile (CME) very far into the bear market but it still went down a lot after I bought but has come way back. I still have one Australian bank and one Canadian bank that are bull market holdovers that I hope to hold forever but if they do something like buy a Merrill Lynch I wouldn't hesitate to sell it right away as was the case with Bank of America (BAC).


So that is the background for anyone new. Going forward I have given up on REITs as diversifiers. While it is true that correlations across the board went higher during the bear the correlation of REITs to financials seemed to go up very early on as opposed to closer to the end like a lot of things did. Not that I will never buy one, just that I have lost faith in their ability to offer diversification.

I am a couple of percentage points underweight versus the index. Domestic financial stocks have roared back price wise to be sure but I don't think the massive run is justified fundamentally.

After going down a ton they came screaming back that is a normal market reaction but I don't really want to put client money into stocks that have no, IMO, fundamental basis for being bought. I have a stock picked out that I expect to buy in the sector that would take me close to equal weight that while clearly a financial is not a bank, brokerage or insurance company--beyond that I'm not going to front run it. I am also open to buying something like Hong Kong Exchanges (HKXCY) for certain accounts down the road but that would be a long way down the road if ever. About all I can say about that name now is that it makes a good first impression (please, do not add 1+1 and get eleven here).

As far as the fate of the US dollar and so on: I have had the same big picture thoughts about all of this for years and they have not changed much because of the crisis. I have felt that the US would have to share its role of world economic superpower. Other countries are growing faster and becoming more relevant in the world economic order; China for all its issues is more relevant than it used to be. This would cause there to be a little less demand for the greenback which puts some upward pressure on US interest rates and maybe gooses up inflation some.

As for inflation I think hyperinflation is off the table. The dollar is likely to have to share the role of world reserve currency. This means that plenty of countries will still need, want and use USD. Allowing it to hyperinflate hurts everyone so it is in everyone's interest to prevent it. That is not to say that inflation can't go up to a point of being quite uncomfortable but hyper seems very unlikely.

Since first putting this together in the early days of this site we have seen rates panic lower as the financial system came closer to a meltdown than people thought possible. My idea for interest rates was something close to 6-7% for long rates but we now have further to travel to that point which means the discomfort of that adjustment could be more uncomfortable.

I would point out that all of these things are likely to play out over many years. Indeed I believe this entire decade will be viewed as part of one massive but slow moving adjustment.

Regardless of the particulars I think the outcome will be similar. This is not doomsday but more of a headwind the result of which, IMO, will be below normal returns for US equity markets which isn't that horrible because we've already been living with that for ten years.

I've been saying we need to increase foreign exposure for years and I think that will continue to be the case. While this has been correct thus far it has also been a very obvious conclusion to draw and I believe no less obvious now.

Comments

[jimmy46:]

I agree that hyperinflation is unlikely, but I think we're going to see
10-15% inflation in the next few years as a result of TRILLION dollar deficits.
REITS's will offer good protection during this time.

The way their prices have partly recovered the last 5 months makes me think that others are on to this also.

Aug 23 12:52 PM

[jasonjim:]

Good quality REITs will follow the financials upwards IMO. Many of them are seriously undervalued, which gives an opportunity not only for their great dividends but also for serious capital gains over the intermediate term.

Aug 23 01:18 PM

[Tack:]

A couple of comments:

1) Diversification can be attained in myriad ways. Certainly, there's no need to avoid REITs, especially commercial REITs, which seem positioned to offer serious upside potential as the economy gradually recovers. Commercial REITs, such as HRP, NRF, DRE and others, are currently priced at 15-25% of their three-year highs, even after the recent rally in share prices. They remain severely depressed because the conventional wisdom keeps waiting for the commercial-realty shoe to drop. However, many commercial REIT's have remained profitable throughout this major downturn and, also, have built up sizable reserves against future losses, even while remaining profitable. My guess is that the bark is worse than the bite will be, as regards commercial realty, and that from their low present values they will offer sizable percentage returns.

Also, many of these REITs offer very attractive preferred shares, which afford outsize dividends that have a very low probability of being cut or suspended. Such shares offer nice returns, even if capital gains are slow in materializing.

2) A new theory developed early in this recession that overseas economies and markets, including China, would continue to thrive, despite our woes. It was quintessential "this-time-it's-differ... thinking. Instead, they plummeted along with the U.S. and even China required a massive stimulus program (at least they have the reserves). The second half of this equation will play out equally, I believe, i.e., either we'll all recover or none will. Personally, I vote for the former, at least in nominally-measured terms.

This means that all world economines will generate renewed demand, when for the first time in decades we've had meaningful reduction in supplies and in capacity. This, coupled with trillions in newly-minted currency that has yet to be fully realized in the system, suggests to me that inflation is a very real threat, an almost inevitable occurence, about which we should be debating whether it will be year one, two or later.

The only way this could be blunted would be if governments, especially the U.S. government, were to pull huge amounts of liquidty out of the economies prior to inflation really picking up steam. The track record for such responsible action is almost universally poor, as politicians are much better at giving than taking away.

My general conclusion, therefore, is to plan for gradual recovery, buy depressed shares and plan for inflation.

Aug 23 11:45 PM

[ilovesum:]

Who's going to keep buying this massive US debt for very little return and a high risk of future inflation cause the US running the printing press?
Why has China been buying "real" things such as commodities with their US dollars ?
Buffett is right there will be sharp inflation

Aug 24 12:56 AM

[Jimbo:]

Buffet's stated portfolio seems to be created for deflation. Perhaps he is now having an "oops" moment. I sure hope Dr. Hussman is correct because his vision is more benign than mine.

Aug 24 10:22 AM

[Emerald:]

So many writers telling us that inflation is on the horizon, although Roger mentions that this is many years out. We are in a defaltionary environment wher the consumer is tapped out and not spending. Banks can't lend to overleveraged consumers and businesses don't need the money. Government spending is not going to bankrupt anyoneas the money is sitting in Treasuries purchased ny the banks. Look at the double digit return the governement received from the banks that have repaid TARP funds. paper profits on other bank inverstments are huge. I don't like the idea of bailing out banks but it will be profitable for the taxpayer.

Most REIT's, especially apartment REIT's have hit bottom and have partially recovered. Many have raised equity and rolled over debt maturities. Yes, there is more bad news to come for some real estate companies in 2010, but others can now be bought at a significant dscount to future value. I would buy more REIT's after a pullback.

Anyone shorting the dollar right now is about to get a hard squeeze. Sometime in 2011, we will start to see a monetization of government debt and inflation. For all those waiting or hoping for the demise of the dollar as the world's reserve currency good luck. And wher will people put their money? The Euro, the Yen, the Canadian dollar, the Australian dollar? After you. Investing in asian companies is a good long term strategy as is in U.S. based companies with a strong asian presence. Fear mongering is not a good investment strategy Note: Long EQR, UUP.

Aug 24 12:13 PM

[Hmm?!:]

jasonjim,

I am sorry, you lost me..... how? There are excess homes built.....sold to people on liar loans. Most of the liar loaners will never qualify for a mortgage again, because they didn't even qualify the first time.

I see new and empty strip malls and newer office buildings converted to warehouse space. And yet I am in Dallas Texas..... a city least hit to date, by the downturn.

We have a 70% consumption economy that is out of money and overbuilt as far as the eye can see????

A lowering tide....... lowers ALL boats!

On Aug 23 01:18 PM jasonjim wrote:

> Good quality REITs will follow the financials upwards IMO. Many of
> them are seriously undervalued, which gives an opportunity not only
> for their great dividends but also for serious capital gains over
> the intermediate term.

Aug 25 01:37 AM

[morssglobal...:]

For more thoughts on the dollar, see www.morssglobalfinance.../

Sep 02 02:44 PM

[Analyste de...:]

I confess I don't know much about this sector - what do REITs have to do with home prices, directly? Aren't most REITs commercial properties? What part of the mkt is "mortgage REITs" ? I'm not confident the US residential RE mkt is recovering, and I think the US commercial RE will get worse - so I don't see any reason to devote lots of time to this sector.

OTOH, I like the intl REIT (RWX) but that's just a 5% stake in my Portfolio Model - it's UP +89% in the Rally so far. Without studying its holdings in great detail, I presume that single fund is diversified enough for my basic purposes. And so it has been!

What other non-US REITs are suggested, as ETFs or CEFs?

Sep 02 05:49 PM

[John Gault:]

@jasonjim

Please elaborate on your thesis that REITs are undervalued. That statement, seems to me, to be based entirely on your uniformed opinion.

Sep 17 01:50 PM

[worriedwart:]

First off read this:

Aabar's purchase is the second major deal announced by Gulf state-backed investors in as many days.

On Saturday, Qatar Holding said it increased its holding in Songbird Estates PLC to 24 percent, making it the biggest shareholder in the real estate company that owns much of the Canary Wharf financial hub in east London.

Qatar Holding is the investment arm of the natural gas-rich Arab state's sovereign wealth fund.

It said its investment in Songbird now stands at more than 350 million pounds, or $559 million. It also owns stakes in European banks Barclays PLC and Credit Suisse Group, British supermarket operator J Sainsbury PLC and the London Stock Exchange.


The Chinese are only holding off for the moment here in the States
I am sure they are buying in but "undercover"
But I know the rest of the crowd is catching on

If we dont get back to capitalism and FAST we are going to be in big trouble

This isnt the Japanese buying in like the 1980's because America as a whole dwarfs Japan BUT NOT CHINA

I say it again:
Because the public schools are Leftist run, they have a conflict of interest in teaching about economics in early grades

The kids will figure out that government spending is a really bad thing and want nothing but capitalism

That aside, ONLY ELECT CAPITALISTS TO CONGRESS IN 2010

And yes, that means no more wasting votes on RINO's

Libertarians or bust!!

Oct 11 09:59 PM