Housing: Dead Cat Bounce With a Silver Lining

 |  Includes: DIA, IYR, KBE, QQQ, SPY, XHB
by: Carlos X. Alexandre

The never-dying subject of housing is hard to miss, and everyone wishes upon a turnaround because a home represents the major asset for the majority of Americans. But if we look back to the 1990s, we had a lost decade in housing prices. Going forward, we’ll lose two decades — best case scenario. The reasons are plenty, and have been well documented, but the debate will go on while reality will take small bites out of people’s patience. And I have a last tidbit on this subject. According to Reuters on December 29, 2010,

The regulators said one reason for the increase in foreclosures is that banks have "exhausted" options for keeping many delinquent borrowers in their homes through programs such as loan modifications. Newly-initiated foreclosures increased to 382,000 in the third quarter, a 31.2 percent jump over the previous quarter and a 3.7 percent rise from the same quarter a year ago, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) said in a quarterly mortgage report. The number of foreclosures in process increased to 1.2 million, a 4.5 percent increase from the second quarter and a 10.1 percent increase from a year ago, according to the regulators. They said during a briefing that the numbers could send "mixed signals" about the health of the U.S. housing market.

Mixed signals? That is a nice way of putting it. Forecasts of a housing recovery are greatly exaggerated, just like I remember “experts” claiming on TV that sub-prime was not a problem and was being blown out of proportion. The positive forecasts are either derived from wishful thinking or a complete lack of understanding of what is truly going on. The magnitude of the damage incurred still escapes many, and Schiller’s House Price Index is a perfect picture of a dead-cat bounce — and as smooth a graph as one can get.

Schiller-HousePrices-12-28-10Click to enlarge

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Having stated what to some of us is obvious, the S&P Homebuilders ETF (NYSEARCA:XHB) was up 14% in 2010, and returned 11% in the last 30 days of 2010, and I understand the disconnect between a stock’s short-term performance and reality. I wrote on December 9, 2010 that Homebuilders were not a good investment, and I meant it for those that believe that the aftershocks of the housing crisis are behind us. Thus, the focus on short-term tradable securities instead of agonizing over asset allocation, and what the Dow will look like on December 31, 2011. It will be higher if capital flows play as expected and the Dollar appreciates.

To add insult to injury in the housing dilemma, the Federal Reserve will increase interest rates, not because they want to, but because the market will dictate it to them. That is the way it has been and always will be — and not due to healthier economic activity.

So where’s the silver lining in all of this? Money must go somewhere, and among three asset classes, only one holds inflationary appeal at this juncture – and capital seeks inflation by definition. First, the three asset classes are Real Estate, Equities, and Bonds. Bonds are further defined as Debt because that is their true nature and I find it soothing to describe things for what they are.

What about commodities? Although one can make a ton of money trading commodities, they lack one trait that is common to the other three core classes: cash flow. Real Estate can produce rent; equities can pay dividends (not all, I know); and Debt pays interest. Commodities only incur expenses — mainly storage — and that is why they’re not in the same class — and never will be.

Thus, if real estate is not attracting capital and interest rates are due to rise, only equities are attractive enough, as long as they deliver higher returns than bank CDs. And there lies the turn. Rates can ride high --- let’s say 10% – and not derail the equity gravy train. And the added rub is that equities will be attractive even without a strong economic recovery, and that’s where international capital flows come into play.

Actually, in 2010, amid all the bad talk about Financials, the KBW Bank Index (NYSEARCA:KBE) outperformed the Dow Jones Industrials (NYSEARCA:DIA), the S&P 500 (NYSEARCA:SPY), and the Nasdaq 100 (QQQQ). And it’s not as if banks have been nursed back to health.

ETF Return 2010
KBE 22.39%
QQQQ 19.13%
SPY 13.08%
DIA 11.18%
Click to enlarge

As the New Year is initiated, not much is different apart from the last two digits on the date. The focus will remain on trading profitably, regardless of all the asset allocation — or misallocation — talk that will ensue, because much will become distorted due to international capital flows. 1987? The climax of a 40% devaluation in the Dollar, which was contrary to common wisdom that holds that a lower Dollar translates into a higher Dow. Not necessarily.

Thus, international capital flows will be at the heart of the market, not whether GDP in the US is +2% or -2%. And this is not a Global phenomenon that just manifested itself in the last 10 years. Once again, that is the way it has been and always will be. 1989? Capital flowed into the land of the rising sun for lack of a better destination. Then Japan popped and is still 75% (give or take) below the crest 21 years later. Tell the Japanese about long-term investing.

While I was out, the last week of trading turned the dollar trend negative – short and long term — and the equity market went virtually nowhere, and I know that the year-end so called “adjustments” for tax reasons were in play. I never truly understood the “tax thing" because if I hold an investment — profit or loss — the end of the year was never a trigger to close a position. What if the loss I was holding turns into a profit 5 days after I took my tax deduction? So I give up. Let’s say 50 cents, for a deduction of 20 cents. Isn’t that a form of “timing the market” practiced by the same people that claim “timing” is impossible? But then again, I never pay much attention to taxes. I learned that from a very old friend of mine, and I shall quote him: “Tax planning is a waste of time. The more I make, the more I pay, the more I keep. Thus, the focus is on ‘make’ not on ‘pay’.”

To close, I believe that there’s an additional item in play. We, the American people, have changed, and our spending mentality has shifted to a more cautious stance that will last for a generation. That is yet another new “normal” that markets must contend with.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.