Thursday, September 18, 2014

Follow up on August inflation, etc.

Several sets of data were updated today, but the picture remains muddled.

The flow of funds data continues to show a decline in household mortgage levels.  Commercial, corporate, and multi-family mortgages are slowly growing.  But, households are stagnant.  The growth in real estate loans at commercial banks may just reflect a slight rebalancing from MBS levels into held real estate loans as a result of the QE taper.  I'm not sure we are seeing any growth in household real estate credit.  And, the level of equity compared to total market value leveled out in 2014 2Q.  At the previous trend, I was somewhat optimistic about recovery in the level of real estate leverage to help re-establish household real estate credit markets.  But, looking at this with fresh eyes, and with the decline in trend, this is troubling.  We need another year's worth of healthy home prices for this balance to be restored.  Without QE, I'm not sure where that is going to come from.  Maybe continued rent inflation and the recovery of bank balance sheets will continue to support funding for institutional home buyers.  But, there is a risk here that housing markets don't recover.  Interest rates may be stuck at zero if housing markets can't  recover.

Source: Calculatedrisk

By the way, August housing starts disappointed, and continued to show a stagnation in home building.  I may be getting ahead of myself on my homebuilder optimism.  We may have a ways to fall before things turn around.  If the economy manages to grow in spite of a lagging home market, multi-unit real estate might see unexpected growth as it fills in the gap on the supply bottleneck.

I wonder if this is the source of pessimism that has held the slope of the yield curve so low.  I have been positioned for a steeper slope.  This is definitely a situation where the market price must reflect divergent potential outcomes.  The yield curve where it stands now might reflect two extreme possibilities - future rates much higher than the current rates (in the 2016-2017 timeframe, at least) or future rates that never get off the ground.  Or, worse yet, rates that rise because the Fed tightens when it shouldn't, and then drop to the floor along with the economy.  I will note that the change in the yield curve Wednesday, when the Fed published their latest position, reflected increased rates in 2015-2018 and decreased rates in the long term.....

Reminiscent of the September 2008 Fed meeting, where the Fed's head trader told the FOMC:
I think it is important to recognize that the rates embodied in those fed fund futures contracts are means not modes. So I would characterize the market expectation as either that things get very, very bad and the FOMC cuts rates significantly or that the FOMC does nothing.
Of course, the Fed did nothing, and thus things got very, very bad.  So, the market was actually right on both counts.  Is this what the market is telling us again, but this time in slow motion?

------------------------------------

On the brighter side, the productive economy seems to be moving right along.  Unemployment claims continue to decline.  Continued claims have fallen well below 2.5 million now.  This suggests a baseline expectation for unemployment that has declined another 0.1% from the August number, increasing the chance of hitting year end with a 5.5-5.7% unemployment rate.

It is looking like we might be headed for an end of 2014 where employment, production, and incomes are churning along nicely, but where single unit real estate stagnates.  An interesting time ahead, I'm afraid.

PS I've added a time lapse of Eurodollar futures to show the change in rates as QE3 has tapered.



Wednesday, September 17, 2014

Inflation, Housing, QE, and the Taper in August

Inflation in August still leaves open the possibility that the Fed has tapered QE3 too soon, making the same mistake they made with QE2.

The recent crisis was marked by a demand crisis that was felt most harshly in real estate credit markets.  So, core inflation (less shelter) is mostly a reflection of demand.  But, since real estate has been limited by the crisis in real estate credit markets, shelter inflation is a reflection of a supply shock.  Further economic recovery will be difficult without further recovery in real estate credit.

If the recovery continues to be healthy, we should see rising Core (minus shelter) inflation due to increased demand and falling Shelter inflation due to increases in home supply as home prices continue to recover and new housing starts increase.  Unfortunately, now we are seeing the opposite.

Here are graphs of Month over Month inflation and Year over Year inflation - Core, Shelter, and Core minus Shelter.  What we are seeing now is continued strength in Shelter inflation, reflecting the shortage of housing while strengthening demand bumps up against real estate credit and new home building that are only very slowly recovering.

Core minus Shelter inflation was strong in late spring, but has now fallen for four consecutive months, including two months of core deflation.

These are noisy series, so there is still hope, but this does leave the possibility open that the taper came too soon and there isn't enough escape velocity in credit markets to push home values high enough to return us to self-sustaining recovery.

Real estate credit doesn't offer any clues.  After five years of decline and stagnation, real estate credit finally started recovering this year.  Real estate credit held at commercial banks has been growing at a rate of about 5% all year.  But, a healthy credit market would be growing by at least 10%.  And, household mortgages, tracked by the Federal Reserve, show even less promising recovery.

I think we need to have home leverage back to normal levels and a natural interest rate above zero in order to escape, and these things will happen together or not at all.  Both are marginally there now.  The recovery is happening in many facets - employment, foreclosures and loan-to-value, commercial and industrial credit, consumer credit, consumer confidence, service and manufacturing indicators, etc.  There are an awful lot of things pushing us in the right direction.  But, this inflation report leaves open the possibility of a slowdown before we get there.

Looking ahead, if the Fed is targeting inflation, we might be looking at a sort of tipping point.  If continued real estate credit recovery leads to new home building and a decline in shelter inflation, the Fed might be lulled into getting too far behind rising demand.  But, if real estate credit stagnates, and a supply shock in shelter causes inflation to surge, the Fed might miss the underlying deflationary trend.  Politically, it would be very difficult for the Fed to open up another round of liquidity injections.  This outcome could be disastrous.

I'm still positioned for the expansionary outcome.  But it bears watching.

Jubilee is the most conservative economic policy ever proposed.

The Biblical idea of the Jubilee has gained some traction out of the economic crisis and Occupy Wall Street.  I think the concept is a good example of the power of framing and how our priors can overwhelm other considerations regarding our observations and conclusions.

The Jubilee is usually presented as a leveling of the field - as an undoing of the accumulation of economic inequality.  But the policy, explicitly, is the ultimate statement of conservative force.  Jubilee, implemented, means that, whatever the distribution of property was 50 years ago, it will be that way for all time.
"This fiftieth year is sacred—it is a time of freedom and of celebration when everyone will receive back their original property, and slaves will return home to their families."—Leviticus 25:10
How in the world did this idea become a Progressive idea?  I think that it is because Progressivism is a conservative political paradigm.  I propose a framework for thinking of political ideology:

Low Respect for Individuals
High Respect for Individuals
Low Respect for Institutions
Progressive
Liberal (US)
High Respect for Institutions
Conservative
Libertarian

Conservatism starts with a healthy Burkean respect for institutions.  This communal respect for institutions, however, naturally lends itself to an ugly bias against outsiders and against groups that are marginalized by existing institutions.  So, the dark side of conservatism is the tendency to judge uncomfortable issues and people from within a comfortable paradigm.  Conservatism becomes vulgar when it leads people to judge others confidently, based on their finite store of narratives, and to impose maltreatment on them through political force.

Progressives tend to work from an oppressor/oppressed point of view.  They tend to view people as members of groups, with varying levels of power and victimhood.  And institutions are important sources of these power imbalances.  These are good motives for a point of view.  They are certainly important ingredients in the development of society and its various injustices.  But, in its vulgar form, it takes on the poor tendencies of conservatism, but without the respect for institutions.  Given the tendency for Progressives to be associated, along with liberals, with the left wing in the US, this leads to ironies like the Progressive rhetorical support for grossly conservative ideas like jubilee.

(Since this post is about jubilee, I am concentrating on Progressives.  But, of course, all ideologies have their vulgar forms.  For liberals, the archetype might be some of the excesses of hippies, and for libertarians it might be some of the excesses of objectivists.)

How does the jubilee become a Progressive idea?  Because of the mistake of taking one's existing basket of narratives and assuming that this set of narratives is the global set of narratives.  In fact, this tendency may frequently be what separates conservative from libertarian and progressive from liberal.

Rhetoric in support of jubilee tends to describe debt in terms of desperation - the accumulation of assets by the wealthy from the poor.  The images drawn are of bankrupt farmers and working class consumers.  These narratives cover an exceedingly small portion of the full range of debt arrangements.  But, jubilee rhetoric seems to treat these narratives as the full set.  This strikes me as the classic conservative error.

In fact, clearly, the distribution of assets and the use of debt, on net, reflect a much more complex mixture of outcomes, with a bias toward economic mobility and equality over time.  If you doubt this, imagine if jubilee had begun to be implemented at any time in the past.  How far back would we need to go to get to a jubilee that would reset ownership that excludes some minorities, or women?  Not very far.  The universality of property rights is definitionally capitalist, and proceeding from these legal advances, previously marginalized groups of people have accumulated assets through market participation.

Even the idea of the jubilee itself betrays this error.  In the ancient context where it was first described, property was largely limited to land, and was essentially static.  Jubilee meant returning to your family's land.  Our society bathes in the continual expansion of abundance, such that if jubilee were ever more than a rhetorical cudgel, the concept would be obviously incoherent.  What would happen to Google stock?  How would the previous owners of Pan American Airlines or Eastman-Kodak return to their previous ownership status?  Modern wealth is lost to legacy owners and created by innovators and traders in ways that were simply not imaginable to the originators of the idea of jubilee.

The US has a very generous bankruptcy policy.  And, a strong history of the development and distribution of new assets outside legacy capital.  Even now, amid the obsession of inequality, we are in the midst of one of the most revolutionary redistributions of ownership from legacy capital to entrepreneurs in the history of the planet.  In fact, the common story of the college buddies (or college drop-outs) developing software or hardware and suddenly becoming billionaires is a large factor in measured trends of inequality.  Even some of the poster children of legacy capital - like the family of Sam Walton - are the custodians of wealth that has been created within the last 50 years.  Modern free society has outdone the jubilee.  It's not even close.  The jubilee taken literally would mean that the small sharecropper who worked and invested his way into a significant landholding would have to give it all back after 50 years.  This is simply a narrative that progressive jubilee rhetoricians deny through omission.  But it is the overwhelming narrative of our age.  It is so overwhelming that this narrative describes a favorite mascot of legacy wealth - the Walton family.  If we had a 50 year jubilee, they would have to give all but a handful of their stores to the owners of the old A&Ps and Ben Franklin five & dimes.

Going down the list of the American Forbes 400, the vast majority have made their fortunes in the form of assets that didn't exist 50 years ago.  If we redistributed assets to families according to the distribution of wealth of 50 years ago, the assets of the Forbes 400 would overwhelmingly be redistributed to families who were wealthier than today's Forbes 400 fifty years ago.  It would be a regressive redistribution.

Denial of the existence of economic mobility has actually led to rhetorical support for the abolition of economic mobility.  Despite this irony, so far the jubilee idea has led to what are probably positive social activities, like Strike Debt and Rolling Jubilee.  These programs appear to be helping households escape consumer debt.

A conservative movement needs the state to impose its favored order, so the progressive movement seems to focus its anti-institutional ire at commercial and religious institutions.  This leads to further oddities, such as the rhetoric of Strike Debt and Rolling Jubilee, which are strongly anti-market, even while their actual activities tend to revolve around medical and educational debts.

Most of these debts will have been incurred to or through public and non-profit organizations and programs (many hospitals and insurers, public universities, federal student loan programs, etc.).  You would think that the fact that these debt problems overwhelmingly occur in the sectors that are far from our best examples of private laissez-faire markets might undercut the narrative.  But framing is so powerful that narratives can remain selective even in the face of impassioned personal experience.

Where our personal experience dominates, the desire that most of us have to do good allows action to trump rhetoric, so programs such as these probably leave the world a better place.  Where personal experience doesn't dominate, such as the imposition of factional values through national political activities, the ironies of our rhetorical errors are more free to undermine reason and civility.  So, while these groups engage in activities, like charitably and legally forgiving debt, that generally respect both institutions and individuals, their rhetoric and political activities tend to respect neither.

Monday, September 15, 2014

What will happen if market trends push interest rates above zero?

I'm no monetary economist, so I really would like to know.  This is my stab at a rudimentary understanding.  I'd love to hear from commenters if I'm totally off on any of this.

First, my understanding is that in modern banks, reserves don't really serve as a direct constraint on lending.  Clearly, they aren't the constraint now for bank lending.  The constraint now must be related to bank capital and regulatory oversight.

Capital conditions among banks continue to recover - credit along with them.  Here is a graph of bank credit and the Fed Funds Rate in the Great Moderation era.  When investment demand dries up in the early part of cyclical downturns, we see bank credit level out and interest rates decline.  Then, bank credit starts growing again, at a remarkably regular rate, appearing to top out at about 10% growth (the left scale is a log scale).  Since 2008, bank credit has been stagnant.  QE filled some of that gap.

Since the beginning of 2014, loans and leases in bank credit have begun growing again at nearly that 10% rate (the little kink up in the blue line in the top right corner).  While real estate loan growth has been part of this return to growth, it has been a very small part of it.  So, I expect bank credit to continue to accelerate as real estate loans recover, although, I am a little disappointed with this credit category.  It has been growing at an annual rate of about 3% since the beginning of 2014, with no real acceleration.  In fact, real estate is still declining as a proportion of total bank assets (minus cash).  But, we are just now approaching the pre-recession level of home equity leverage, so there is still a lingering headwind of household deleveraging.  I still expect to see real estate credit accelerate soon, as we leave that constraint behind.  But, if home values stop moving up and there isn't enough momentum to develop real estate credit growth, we could be in some trouble.

(Calculated Risk notes that some are seeing price concessions among home sellers in California.  I still suspect that this is a kind of negative head fake as the buyer's market switches from QE funded cash buyers to bank funded mortgage buyers.  Partly what makes me optimistic about intrinsic home values is that I think it is quite amazing that it is considered notable that some sellers are capitulating on price when there has been no support for the real estate market from the banks for more than 5 years.)

In any case, it appears that normally within a few months of bank credit growth reaching that terminal growth level, credit demand begins to push interest rate levels upward.  This is the "We are the 100%" economy, where emergent growth leads to surplus.  Wages, interest rates, and profits all tend to move up in this context as equilibria prices among all of an economy's participants float upward so that all share some of this surplus as a result of countless marginal adjustments.

The natural interest rate has been negative, and QE has replaced the commercial banks as a source of liquidity in the economy.  But, as QE3 unwinds, it appears that banks are emerging as credit creators, and so I think we should expect the typical patterns to follow.

But, with excess reserves at the banks, I think there should be a limit to interest rate pressures.  I think the net result of increasing credit demand will be to draw credit outside the banks, as banks hit their capital constraints.  Reserves will still end up at the banks, but I think this will lead to a residual increase in currency in circulation and maybe inflationary pressures.  So, I wonder if an increase in currency in circulation will be a sign that there are natural upward pressures on short term interest rates.

The Fed intends to lift both the Fed Funds Rate and Interest on Reserves in order to move rates up before they pull all of the excess reserves out of the system.  But, with $3 trillion in cash at the commercial banks, a 1% rate increase on reserves means $30 billion in additional annual capital going to banks or depositors.  Banks could parlay that $30 billion into an additional $150 billion in loans and leases.  I suppose the Fed will be selling treasuries at the same time, which should have a slight disinflationary effect.

So, if we don't see an acceleration in bank credit, I wonder if we should be watching currency in circulation for a first sign of interest rate pressures, followed by inflation levels that outpace currency changes while interest rates rise.  This is a graph of currency in circulation, adjusted for consumer inflation.  In addition to watching for an imminent increase, this also is an interesting indicator moving into cyclical downturns.  I don't know if the decline in this ratio is a sign of Fed monetary tightening or if it is a product of, say, relative inflationary pressures on consumer goods as investment declines.  Or, it could simply reflect a lower propensity to hold cash when short term rates are high.  When the first derivative goes negative, it seems to be an early recessionary signal.

So, I'm in over my head on this one.  I'd love to be corrected in the comments on my mistakes.  Don't fail me, readers...

Friday, September 12, 2014

The New Economy

Here is a little fertilizer robot that scoots around between corn stalks and precisely applies fertilizer. This is a reminder, to me, of how much 21st century economic growth consists of a reduction of consumption.  This robot wastes less fertilizer, creates less chemical run-off, replaces some tractors, allows for more fallow land, etc.

There are milking operations now that basically are robotic.  The cows mosey in when they want to get milked (and have a snack), and robotic milkers take care of business - no farmer required.  When I was a child, dairy farmers had to report to the milk house every 12 hours, rain or shine.

Some of these improvements might be accounted for in lower real costs for the finished goods they contribute to.  But, I am struck by (1) how many improvements in the level of negative externalities, quality, and availability we are seeing in sundry goods and services - from internet-based services and delivery, automation, miniaturization, etc. - many of which must not be captured by our measures of economic growth, and (2) how we may be entering a period of history where economic growth corresponds with less consumption, turning ancient Malthusian inevitabilities on their heads (at least until Robin Hanson's ems start to multiply).

The fetishization of manufacturing labor over service labor is an example of the backward looking nature of our cultural biases.  The transition from manufacture to service is a progressive piece of this movement toward a better world.  The drumbeat of status-knocking dismissals of service work in the guise of altruistic public posturing does not serve this end.  (The portrayal of service workers in television and movies always strikes me as disconnected from reality.  The service workers I meet are generally polite and respectful, whereas their fictional counterparts tend to roll their eyes and chomp on gum.  I suspect there is a bit of projection going on there from the people who write and act in those productions.)  The new, better world our grandchildren will create will be dominated by human-to-human services, probably including the resurgence of positions such as personal servants.  In fact, many goods and services will, in effect, be commercialized status signaling rituals - such as artisanal production, entertainment, grooming and dressing, elective physical therapies, etc.  That's what people do when our basic material needs are met.  Our ethical biases were developed in a world where technological progress tended to take the form of mass production - when economic improvement meant digging more iron out of the ground.  To the extent that we judge these economic tectonic shifts through our 20th century ethical lenses, we are likely getting in the way of the progress of humanity and the earth we live on.  Our grandchildren will care about our distaste of service work about as much as we care about our grandparent's distaste of sexual equality, social media, etc. - that is, not much.  And they will be better for it.

Thursday, September 11, 2014

Interesting Paper on Health Costs

This paper from NBER finds cost savings from limited provider network plans. (HT: MR)  From the abstract:
...spending on primary care actually rose for switchers; the reduction in spending came entirely from spending on specialists and on hospital care, including emergency rooms. We find that distance traveled falls for primary care and rises for tertiary care, although there is no evidence of a decrease in the quality of hospitals used by patients. The basic results hold even for the sickest patients, suggesting that limited network plans are saving money by directing care towards primary care and away from downstream spending.
To me, the take-away here is that these plans are sneaking in a sort of first-person cost sensitivity in the form of a convenience premium.  Plans that have convenient primary care but less convenient specialized care end up having somewhat higher primary care expenses, but much lower downstream expenses.  Even though the patients have little monetary exposure to their health care consumption, these plans create non-monetary expenses by increasing the inconvenience of using those services.  This lowers patient demand for the services.

Because the current system has removed expenses so far from the user, we almost all use thousands of dollars of health care services every year that are almost wholly unnecessary.  We frequently engage in testing that costs thousands of dollars, on the advice of doctors, that they would never suggest and we would never agree to if we were expected to pay for a meaningful portion of the cost.  And, this is a subtle issue.  Some readers probably naturally read this paragraph and have a Dorothea Lange picture in their head about a destitute mother deciding whether to treat her son's staph infection or to feed the other three kids for a month.  We need to be careful not to smuggle in other problems here.  We literally spend billions - trillions - of dollars on useless services in this country every year.  Those are trillions of dollars worth of resources that could be used to feed those kids.  There is absolutely no point in building outrageous levels of waste into a system in the name of helping the least fortunate.  Dysfunctional markets for essential services hurt, first and foremost, the most marginal families.  A system that spends thousands of dollars on the most basic health issues, mostly in waste, is not helping, and insisting on a system that tends toward that end, in the name of marginal families, is not responsible.

...Anyway, the subtle issue here is a fundamental driver of how functional markets create dynamic, moral societies with abundance.  This is basic Hayek.  Those prices are information.  Being confronted with the cost of health services, at a first-person level, is a necessary ingredient for us to make moral, responsible decisions about our healthcare.  We simply can't do it without them.  When our doctor gives us an order for thousands of dollars of tests because our kid has a stomache ache that might go away in a few weeks with some basic home remedies, she is partly covering her ass, she is partly helping us cover our ass, she is providing us with the only solace she has available for the dilemma of dealing with an ailment that is overwhelmingly likely to be benign, but has horrendous outcomes way out on the very long end of the tail of the distribution of possible outcomes.  It is immoral for us to fill that order.*  But, without the price signal, all of these other forces - forces in defense of the doctor, ourselves, and our children or elderly parents - all of these other forces win out.  So, we go do the immoral, and we don't think about it for a minute.  We waste enough medical resources to provide for that poor mother a thousand times over.

This is a core, fundamental, moral problem.  Prices are necessary for a moral usage of resources.  And, damned if they are ever allowed to help us create a moral health care system.  Note, I'm not saying it would be easy to balance all the other factors we would need to create a just health care system.  Prices are a necessary ingredient in a just health care system, and the other details won't be easy.  But, without step one - first-person prices - we're just pissing in the wind.

I think that partly what is going on in this study is that having to deal with scheduling or having to drive an hour across town to go to a specialist's office is bringing in enough first-person cost to trigger some minimal level of demand constraint for the doctor and the patient.

This just shows how much low hanging fruit is available in the health care sector simply by getting rid of some of the 3rd and 4th party payment structures.  It might be the case that limited access networks are the closest we can get to this low hanging fruit on a national scale.  We would probably be able to learn a thing or two about these possibilities if there were more options at the state level for health care reform.


* Imagine your reaction to finding out that a trust-fund college student threw himself a birthday party and spent $3,000 just on some ice sculptures for the party.  It would leave a bad taste in your mouth, I suspect.  Our hypothetical student probably had just as much of a disconnection from the costs and received just as much benefit from the sculptures as you likely did from the some recent diagnostics you or your family have undergone.  Defending a system without first-person price signals is the moral equivalent of defending trust-fund ice sculptures.  Creating a national public program to specify and fund unnecessary birthday ice sculptures for 90% of the population probably isn't much of a moral victory.

Wednesday, September 10, 2014

Reshorings aren't happening - and that's a good thing

According to research by Jim Rice at MIT, reported by Robert Wright at The Financial Times, (HT: EV) reshorings - the movement of offshored production back to the US - have been overstated.  This seems to be generally viewed as a problem, because this production is associated with jobs.  But, I think this view is misguided.

If we found that more Americans were also returning to agricultural work, that would also be bad news - as would be a surge in jobs among typists, blacksmiths, and ice handlers because Americans had given up computers, cars, and freezers.

The widespread error of attributing the growth of foreign production to low wages creates these sort of misinterpretations.  It is better to think of the application of functional public institutions, such as universal, transparent property rights, the ability to engage in commerce with minimal harassment, etc. as an improvement in technology.  Foreign production is the result of this technological advancement, which attracts capital and produces higher wages for local laborers.  The production is moving to where wages are rising.  Those wages are low because of the pre-existing dysfunctions.

The growth in foreign production - which, in the emergent, decentralized system of commerce that creates abundance will inevitably result in the movement of some existing production - has created dislocations.  All growth creates dislocations.  The existence of dislocations is not a valid reason for the elimination of growth.  For instance, we should not reverse the cultural and legal equality of women just because it means that men have to adjust to having fewer privileges - even if some of those adjustments are difficult and if some of them are borne by men who are not especially privileged.

As with much technological improvement, the effect of these changes is to free labor up to create new goods and services that we couldn't produce before - frequently they are goods and services that we never conceived of before.  These are jobs that are good news.

This notion of jobs being taken away or underbid leads to a backwards looking framing, where we want to fill the jobs gap with jobs that represent economic regression.  This is one of the core sources of conflict between the neo-liberal conception of the economy and conservative economic conceptions (oddly associated in the US with "Progressive" factions).  The best forward-looking way to fill the job gap is to create a legal and cultural context where the obstacles to creating those new goods and services are minimized.  This involves a sort of faith in the ability of markets to create things that exceed our individual imaginations.  Faith is probably too strong of a word for this.  It's akin to having faith that your heart will keep beating through the night.

Tuesday, September 9, 2014

Speculative Position in Housing, Part 2

In last week's post, I forecasted a 75% - 100% growth in homebuilder revenues over a 3 year time frame.  Firstly, I'm not sure that that forecast is really much outside the typical forecasts for some of the individual builders.  Also, it's not outside the range of outcomes from the previous expansion cycle.  Here is a graph of 3 year revenue growth rates for the homebuilders as a group, and another graph of 3 year revenue growth rates for the individual firms.


The entire industry experienced that rate of growth for a decade.  My hunch is that bottlenecks in credit creation, home price trends, and builder capacity create a sort of growth ceiling in that range, and that the homebuilders will plateau at that range.  The question will mainly be how long will it persist.

In the 2000's, there was a fairly wide range of growth levels.  Converting back from logarithmic to a geometric scale, except for a couple of outliers, the range was generally from about 60% to 120%.  The relative position in this range is obviously an important consideration for valuing each firm, but this post is simply intended as a framing device for creating a starting point for speculative positions.


Annual Growth Rates
Here are a couple of graphs comparing industry revenue growth with growth in total home equity.  This uses a more thorough sum of revenues than the one I used last week.  The first graph shows the fairly tight correlation over a three year period between industry revenue growth and home equity growth.  Also, when we look at trailing 3 year time frames, the revenue growth for homebuilders from 1999 to 2004 was very consistently around 93% (shown in the graph as about 66% logarithmic growth).

In the next graph, we can see how equity and total real estate market value tended to grow together until the monetary crisis caused homes to be overleveraged.  Also, we can see that a homebuilder revenue forecast (on a YOY basis) based only on home equity levels has pretty accurately tracked actual revenue, especially over 2 to 3 year periods.

Further, homebuilder valuations track revenues fairly well.  Here is a graph of homebuilder revenues, enterprise value, and market capitalization.  (Note, I am using a kind of lazy enterprise value here that consists of total liabilities plus the market capitalization of equity).  Here, we can see that there has been roughly a floor of 1 on the EV/Rev ratio.  Currently, the market capitalization also reflects about $6 billion of tax assets from the downturn, many of which are still off-balance sheet (as of the end of FY2013).  We can see here that the market is anticipating growth.  So, there already is a large deviation between Enterprise Values and current Revenues.  Much of this, surely, is in anticipation of some future growth.  In fact, for the entire industry, Enterprise Value already reflects a near doubling of Revenues.  Again, this suggests to me that my home market value and homebuilder revenue projections are already being anticipated, at least within the homebuilder equity market.

So, as a broad brush framing for speculative opportunities among homebuilders, I will compare the gains to equity holders, given certain increases in revenues, with forecast valuations based on EV/Rev=1.  In the 2000's, firms tended to converge at a Market Cap / Enterprise Value ratio of about 50%, so in this broad comparison, I will assume that operational liabilities will eventually limit market cap to this ratio.

Below is a table of homebuilders comparing several metrics:


The first column compares the potential equity returns of the various major homebuilders, given a growth of 90% in revenues.

The second column compares the growth required in each builder's revenue in order to justify today's share price, at an EV/Rev. ratio of 1.

The third column compares consensus 2 year revenue growth estimates for 2014-2015.

I think it is interesting that the weighted average 2 year growth rate is under 40%, with a standard deviation of about 16%.  This is very low compared to any year since 1996, outside of the crisis years.  The 120% break even growth rate suggests that the market has already priced in high expectations for future homebuilder revenue growth.  But, this isn't reflected in the conservative analyst growth expectations.

It is a common dilemma in forecasting that forecasts tend to have less variance than actual outcomes.  So, I think it is likely that homebuilder prices reflect expected growth that isn't being reflected in published analyst estimates.  This could reflect a consideration of highly negative outcomes in the analyst estimate figures, bringing the expected values down, or it could arise from anchoring effects where, in highly volatile contexts, the most accurate forecasts will seem unreasonable ex ante.  The market seems to be generally pricing in a bullish revenue expectation.

In the fourth column, I have simply tripled the consensus 2 year growth rate, to arrive at a sloppy estimate for 3 year growth rates in a bullish home market.  This is a broad attempt to capture the relative expectations for each builder while adjusting the consensus to my bullish expectations.

When I compare the expected returns to equity for each homebuilder to each homebuilder's current financial leverage (estimated with MC/EV), I find a systematic relationship where the less leveraged firms have the lowest expected returns and the most leveraged firms have the highest expected returns.

The expected returns of the safest homebuilders (in terms of leverage) show here as negative because I am using a static valuation forecast of EV/Rev.=1.  But, for the least leveraged firms, lower equity risk premiums due to the lower leverage would lift their static relative valuation levels.  So, while I haven't engaged in this adjustment here, one can imagine the right hand of this relationship being pushed up by this factor, so that the returns of the least leveraged firms will tend to be higher.  My broad measure here does not account for the accumulation of profits during the 3 years elapsed, so if we imagine the healthiest homebuilders earning reasonable profits during this time, as they certainly would, then a firm showing a negative return in my estimate could still provide investors with reasonable expected returns, due to both earned profits and to the higher terminal relative valuation.

In effect, this has simply been a long exercise in finding high forward-beta equities.  The forward-betas of the most leveraged homebuilders should be extremely high, since a bear market would probably kill them and a bull market will lead to positive results from operating and financial leverage, including additional leverage through options on land.  The hypothetical exposure of these builders to fluctuations correlating with the broader market are probably well in excess of 2.

So, this really is just a regular, crude beta play.  Not that there is anything wrong with that.  If you are confident in a bullish forecast, especially in a high equity risk premium environment, grab some beta - as long as you know the risks.  But, I think when betas get this high, there is an added kick that is available to expected returns.  Because, with such highly variable securities, where the terminal valuations will almost certainly be very different than the beginning valuation, the position becomes more of a play on the first derivative of the beta.  If these positions go south, beta will be irrelevant.  The equities will have little or no value in any case.  But, if conditions evolve such that these positions accrue gains, leverage will decrease, operations will normalize, and these firms will start to look normal.  I'm not sure that in extreme contexts, this potential gain from changing beta is efficiently priced.  And, in extreme contexts, this can be a significant source of gains.

One last point from the scatterplot graph.  The most leveraged firms also tend to still have the highest levels of tax assets remaining from the losses they recorded during the downturn.  The red series in the graph reflects market cap with tax assets (both on- and off-balance sheet) subtracted.  Beazer and Hovnanian had market caps at the end of 2013 barely as large as their tax assets, and both have seen falling market caps since then.  And tax assets reflected about half of KBH's equity value.  This adds another layer of leverage.  To a certain extent, with these three builders, there is a discount being applied by the market to their tax assets, based on uncertainty about whether they will be able to utilize them.  This also is a factor which might not be efficiently priced, due to the highly variable, bilateral distribution of probable outcomes.  And, this should be another source of additional gains, to the extent that a bullish forecast is accurate.

It might be the case that the market is generally pricing in a bullish expectation for the industry, but is discounting the lowest quality equities using less bullish expectations.  Or, it could be that the prices of the safer builders reflect the potential gains that would come to them in bad scenarios from the exit of the less stable builders from the market.  This seems unlikely, though, since the riskier homebuilders represent a fairly small portion of the industry.

Here are some individual comparisons of Enterprise Value and Revenues over time.  Beazer, Hovnanian, and KBH are the three riskiest positions highlighted by this analysis.  And, while each of them had Enterprise Values above Annual Revenues at the end of 2013, the difference could be mostly attributed to tax assets.  (My measure of Enterprise Value is total liabilities plus market cap.  Normally, Enterprise Value would be calculated by deducting cash from debt and adding market cap.  I think the lazy version of EV that I am using here gives a relatively stable indication of firm capital, except where firms have large holdings of tax assets.  These have some cash value which will be reflected in market capitalization but should probably be deducted from Enterprise Value in order to create a stable relative valuation measure, compared to the pre-crisis firms.)

Meritage and Ryland are safer options that, at first glance, may have some upside potential in a bullish market.  Note that these firms were priced well above EV/Rev.=1 at the end of 2013, even though they had relatively few tax assets remaining.  So, their higher valuations reflect higher growth expectations and higher terminal valuations.

Note that in all cases, in the pre-crisis period, EV/Rev.=1 provided a fairly stable valuation metric across firms, with all firms approaching or exceeding that level at some point, and several of the firms following that level fairly closely.  Keep in mind that this is a comparison of annual revenues (a flow) to Enterprise Value (a value), so that during the year, prices fluctuate tremendously, and over a period of months the Enterprise Value would tend to fluctuate above and below the revenue level.  Enterprise Value here is a combination of the year end balance sheet and a rough, informal estimate of market cap near the end of the calendar year.





Monday, September 8, 2014

August 2014 Employment Report

I'm sticking to my guns here.  I still think we are due for a gap down in the unemployment rate.  There is a range of about 0.4% of potential reported unemployment in any given month, and I think the odds are that this month's reading of 6.1% (which was under 6.2% by a hair's breadth) was a product of riding the top of the statistical range of a declining rate, as opposed to a leveling off of the trend.

Here are the durations from the past several months.  All of the short duration levels rose.  Especially considering continued declines in insured unemployment, this movement seems inaccurate.  Generally, these durations level off after labor market recoveries, with a continued slight drift downward, and a lot of month-to-month noise.  That is almost certainly the case here.  The 0-4 week category, by itself, was about 0.1% above the average from the past 6 months.  The 15-26 week category had fallen to 0.90% last month, but moved back up to 0.95% this month.  We could conservatively expect this to decline to 0.80% before it levels off.  This month's reading was probably also nearly 0.1% above the trend for the category, although this depends partly on expectations for upcoming months.

Back in May, after the April report, I outlined a detailed forecast of how we might expect unemployment declines to play out for the rest of 2014.  Here is a graph comparing that forecast to the actual August reading.

The reading for August long term unemployment came in very close to expectations - both among the very long term unemployed, who are declining at a fairly linear rate, and the regular long term unemployed, whose movement should generally mimic the 15-26 week group, with a lag.  The chart shows the rise in the shorter durations.  But, the real wild card here is 15-26 week durations.

I would expect this to quickly settle 0.15% lower than it came in at for August, and I would also expect this to lead to another 0.2% drop in 27+ week durations, as those better performing cohorts move into the longer durations.  So, the difference between this being a trend versus noise could mean a 0.3%-0.4% difference in the rate at year's end.  As in April, I believe this month mostly reflects noise, so over the next 4 months, if this month did reflect noise, trends would lead to these reductions:

0-4 Weeks 0.10%
5-14 Weeks 0.05%
15-26 Weeks 0.15%
27+ Weeks, Reduction from August ST Levels 0.05%
27+ Weeks, Reduction from Forecast ST UE Declines 0.20%
27+ Weeks, Reduction from Very LT UE 0.20%
Total 0.75%

Some of the 27+ reduction from future short term unemployment improvements would probably not develop until 2015.  So, this basically puts us at 5.5% in December.  However, this hinges on seeing a continued downtrend in the 15-26 week duration bin.  If we don't see that downtrend, though, this still points to a 5.7% rate in December.

Here is the rate of exit from 15+ week unemployment.  As a confirmation of the notes above, even if this indicator levels off at 40% as we exit 2014, which would be low compared to past trends, it would point to a decline of about 0.3% in long term unemployment between now and December.  That, plus a pull back of about 0.2% in the shorter durations from the unusual levels this month, puts us at 5.6% in December.

In the meantime, continued claims continue to fall - dropping below 2.5 million this week.  This level of unemployment insurance claims has normally coincided with unemployment in the 4.5%-5% range.  Adding the 0.8% of very long term unemployed to that, again, puts us in the mid 5's.  That is based on today's continued claims rate, which still appears to be falling.  So, I continue to believe that the unemployment rate is an outlier.  In this chart, I have separated my estimate of the unusual long term unemployment from regular unemployment to help see the relative level of unemployment to insured unemployment.

Flows are showing the same odd story.  All the flows are showing the same general trends toward normalcy - except the Employment-to-Unemployment flow, which has been unusually high since April.  The difference between the blue line and the green line is the net flow from unemployment to employment.  This is at odds with the data from unemployment insurance from the past 4 months.

The next graph is a comparison of initial unemployment claims and the flow from Employment to Unemployment.  These series move together pretty reliably, except the Employment Flow data is much noisier.  This makes sense, since the flows data is a survey series and the initial claims data is a count.

Keep in mind that these are flows, so that deviations are additive.  In the last 4 months, the unusual rise in the EtoU flow has accounted for about 0.2% of added unemployment.  This flow is probably due for a sharp decline.

Maybe it's just that I said this before the April report, when unemployment was still at 6.7%, and I'm just running on a boost of testosterone from being able to pretend that I know what I'm talking about:
This month could be a real shocker, IMO.  And, I still think we might be tickling 6.0% or at least very low 6's by summer.
 I think a lot of the same dynamics are in place.  From December to March, we were pegged at 6.7% despite strong signs in other indicators, then it all came out in April, dropping to 6.3%.  Now, 4 months later, we barely scratched at 6.1%, despite strong JOLTS and insurance data.  We'll see how the month goes, but I suspect I'll be looking for a drop to 5.7-5.8% in September, which will set us up for a slower decline going forward from there.

Thursday, September 4, 2014

Speculative Position in Housing

I have written many posts regarding my bullish position on home prices.  This early post on the topic probably gives a decent overview of my narrative.  So, I won't recap my thesis here.  My starting point here is simply that home prices in the 2000's were not as excessive as is widely imagined.  Low real and nominal interest rates led to a boom in nominal home prices and that led to excesses with regard to low down payments, subprime mortgages, bank speculation, etc. (not the other way around). Prices might have moved into an unjustifiable range toward the very end of the episode, but for the most part, price stickiness in real estate was preventing markets from clearing efficiently.  The large amount of speculation going on at the time was a product of sticky prices that were slow in catching up to intrinsic values.  (This is where we should expect to see speculators.  Part of what creates a false narrative about the housing market in the 2000's is the perverse colloquial belief that speculators are largely engaged in pushing prices away from intrinsic values, as opposed to collectively making markets more efficient.  People who understand markets tend to understand this common error explicitly, but the power of our aesthetic sensibilities on these matters is such that the error seems to sneak into common interpretations of events like this by informing priors without ever being stated explicitly.)

Here is a graph of Home Prices relative to Rents and Mortgage Rates.  I have discussed in my previous posts how most of the rise in prices could be justified by the low long term interest rate environment.  Average New Home prices and the Case-Shiller 10 City Index have markedly different behavior in the 2000's.  Please comment with any insights that you have about this or links to discussions.  I'm not sure that I completely understand the causes for these differences.  In either case, I am not that interested here in arguing for a specific value.  Only in pointing out that home prices have a lot of room to move up rationally.  Long term interest rates could rise nearly 2 points without moving above the low rate environment that was in place in the 2000s.

Here is a graph comparing relative mortgage payments to rent.  (A caveat: over very long time periods, differences in the underlying adjustments of these data series may cause some divergence.)  Mortgage payments are extremely low compared to past relative levels.  Keep in mind that while lower inflation premiums should lead to lower mortgage payments, lower real interest rates should actually increase mortgage payments, relative to rent.  Even if mortgage rates increased back to 6%, with no change in home prices, mortgage payments would still be lower than rent, indexed to 1987.

Current Home Price Trends
Rent shows YOY change, Home Prices show MOM change
Home prices have been recovering, generally over the past couple of years.  Some of the more sensitive indicators are showing some leveling out.  Here is the Case-Shiller 10 City Price Index (both seasonally adjusted and not) and the CPI for rent.  There are some difficulties with the decline of distressed sales and its effect on seasonal adjustments.  It generally appears that home prices are settling down to single digit annual increases.  But, it should be noted that all of the post-crisis growth in home values has come from institutional and cash buyers.  Mortgages have been stagnant since early 2008.  Nominal home prices, at least according to the Case-Shiller indexes, are roughly back to where they were in early 2008.  And, the long-standing typical balance between mortgages and equity values has roughly been re-established.

This is where QE3 was so important.  Its effects on bank credit, inflation, and real economic growth may have been muted, but, since the 4th quarter of 2012, household real estate market values have increased by about $3 trillion, and this was likely goosed by the added liquidity.  This greatly reduced household real estate leverage.  Without this boost, household credit markets would be dead in the water.  But, QE3 basically carried us back to a place where household real estate markets might be able to achieve sustainable growth without further infusions of cash.

Now that housing has recovered from the demand/deleveraging crisis, we should see a sort of self-healing circle as mortgage and equity grow together, which will allow traditional home owners to bid prices up to their reasonable levels.  To the extent that home prices have slowed their re-ascent, I think this is a temporary lull as mortgage growth kicks into gear.  It would be quite normal for mortgages and total real estate market values to enter a period where both are growing by about 1% per month.  Some of this will play out as new home production and some will play out as price appreciation.

I need to clean up my data a little bit on the homebuilder revenues,
but this is pretty close to the consolidated outcome of the public firms.
For the purposes of a position in homebuilders, I'm not sure that it matters that much what the divide is between price appreciation and new home construction.  Total home equity and total market value of household real estate seem to correlate fairly well with revenue growth among the home builders.  So, for the purposes of this proposal, I am going to avoid the problem of forecasting new home starts, rent inflation, and the price to rent ratio.  These factors will settle into an equilibrium reflecting the factors I have touched on before.  I am going to rely simply on the historical tendency for total household real estate market values to grow in the range of 10% to 15% per year during periods of expansion, and I will use this value to forecast home builder revenues.  This range probably isn't accidental.  This probably reflects the limited ability of the housing market to reach new value levels because of issues like production bottlenecks and sticky prices.  I am convinced by my previous housing analysis that the price pressures on homes are strong enough to continue to push market value growth to that level.

I had originally tried to conceptualize the home builders in our current volatile context as a sort of stable building operation sitting on top of a big pile of real estate assets, so that, in this context, they would effectively be land speculators, even if they don't tend to operate or view themselves as such.  But, I could not find any systematic way that large fluctuations in land values were moving into their bottom lines.  The fluctuations in the real estate market came to the home builders' bottom lines through higher volumes and some margin expansion.  As much sense as it makes to me to look at a firm, like Hovnanian for instance, as an incredibly leveraged option on land appreciation, for some reason that I don't understand, it seems like the bottom line really is a product of operations, and profits seem to come from revenues in a pretty straightforward way.

So, as a basic framework for looking at a position in the industry, I would start with an expectation that by 2016-2017, total homebuilder revenues will be 75% - 100% higher than they currently are (which correlates to total household real estate 30%-40% higher than the current level).  Keep in mind, while I think a 30%-40% rise home price-to-rent ratios from where we are is not outside the realm of reasonable expectations, the total increase in household real estate is a combination of rising rents, rising price-to-rent, and new home production.  So, this forecast could play out even if we just see an increase in the teens for Price-to-Rent ratios.  I would say that, given current trends, something like a 4% increase in the housing stock, a 10% increase in rent, and a 15% increase in Price-to-Rent, over a 3 year period is actually a fairly conservative forecast.  And, that would get us into a 30-40% range for total real estate values.

I think this is more optimistic than the typical forecast for homebuilder revenues.  I am basically forecasting a positive outcome fairly far out on the probability distribution represented by current market prices.  This forecast can be very specifically targeted by taking a highly leveraged position.  Looking at a firm like Hovnanian, which has very high financial leverage that in many cases is funding claims on land that are, themselves, options, and where I can take a position in out-of-the-money call options on the firm's equity - I can take a position that is leveraged to the third power, and each layer of leverage is really high leverage with insurance on the downside.  I love these sorts of positions, where I can isolate my speculative idea and expose myself to tremendous upside with very little downside.

I will follow up with a second post tomorrow.