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R3: FO, CMRG, AZO, WMT

R3: REQUIRED RETAIL READING

December 8, 2010

 

 

 

 

RESEARCH ANECDOTES

  • Is “big and tall” the next “big” growth concept in retail?  After Casual Male announced a collaboration with Sears and JC Penney announced its intentions to build a freestanding big and tall concept, Men’s Warehouse now plans to test a few freestanding stores.  While MW already has a $300 million business serving this growing customer segment, this “test” will represent the company’s first efforts at running stores with a dedicated big and tall product offering.
  • AutoZone noted that the company’s acceleration in same store sales was likely due to two key factors.  First, the extended warm weather trends that carried into the fall were favorable for DIY auto purchases.  Second, the extended macroeconomic malaise continues to be a key factor in consumers holding onto their vehicles longer and as such require more maintenance.
  • With holiday e-commerce sales up 12% so far (Nov 1-Dec 3), there is clear bifurcation between the performance of the larger retailers vs. the smaller ones.  Market share for the top 25 largest online retailers has increased by 6% so far this holiday season, topping out at 68% of the overall market.  Sales growth for the top 25 retailers has been about 20% while small and medium sized business have been trending flat. 

OUR TAKE ON OVERNIGHT NEWS

 

Break Up at Fortune Brands - Fortune Brands Inc., facing pressures from an activist shareholder, announced plans to either sell or spin off its Acushnet Company golf unit, which includes Titleist and FootJoy. The company will also spin off its home and security unit to shareholders in a tax-free transaction while keeping its distilled spirits business. Fortune Brands said its Board has directed management to develop detailed separation plans for consideration and final approval by the Board. The company expects to complete development of these plans - including the structure, timing, and other related matters for each business - within the next several months. "We are taking the next logical step in the evolution of Fortune Brands, which we believe will maximize long-term value for our shareholders and create exciting opportunities within our businesses," said Bruce Carbonari, chairman and chief executive officer of Fortune Brands. "Today's announcement is the result of an ongoing strategic review process conducted by the Board and management over the past four years that included regular evaluation of separating the businesses at the right time to serve the best interests of our shareholders. While the breadth and balance of our portfolio have served shareholders very well, we see the potential for even greater value by separating our businesses into focused companies at a time when they have emerged from the economic downturn in such strong positions. We believe now is the right time to move ahead with this tax-efficient approach, and we're confident the course we've outlined today generates greater potential long-term value than all other alternatives." <SportsOneSource>

Hedgeye Retail’s Take: Expect the common denominator of Bill Ackman to add confidence to those who believe he will have success influencing change at JCP.  Unfortunately, JCP’s same store sales appear to be accelerating which makes a true case for change (be it strategic or management) less credible. 

 

Wal-Mart Plans to End Extra Pay in U.S. for Sunday Shifts - Wal-Mart Stores Inc., the largest private employer in the U.S., plans to stop paying staff there an additional $1 an hour for working Sundays, taking a bite out of its single biggest expense.  The move, which takes effect next year, applies only to employees hired after Jan. 1, spokesman Greg Rossiter said in an interview yesterday. The move wouldn’t affect the Bentonville, Arkansas-based retailer’s 1.4 million current U.S. staff. Since taking over almost two years ago, Chief Executive Officer Mike Duke has pledged to slow cost growth as the retailer copes with six straight quarters of sales declines at U.S. stores open at least a year. Operating expenses rose to about $80 billion last year, partly because of health benefits. “It’s sad -- people who work on Sunday need that extra dollar,” Cynthia Murray, a Wal-Mart employee at a supercenter in Laurel, Maryland, said in an interview. Murray said she makes $11.20 an hour, and doesn’t work Sundays. The move won’t apply to employees based in Rhode Island and Massachusetts, who weren’t eligible for the extra pay owing to state employment laws, Rossiter said. The retailer has 49 stores in Massachusetts and 10 in Rhode Island as of this month, according to its website. The change will take effect at Wal- Mart stores, Sam’s Club outlets and warehouses. <Bloomberg>

Hedgeye Retail’s Take: While prudent cost cutting is necessary to protect WMT’s bottom line in the wake of a sluggish topline, we wonder if the negative PR associated with this announcement is actually worth it.  Happy employees usually equal happy customers.  Will there now be a growing riff between new and old employees working on Sundays given the wage discrepancy? 

 

Jessica Simpson Brand Expands into Sportswear - The Jones Group has partnered with Camuto Group to design sportswear for the Jessica Simpson Collection for fall 2011. The line, retailing from $39 to $129, will include jackets, woven and knit bottoms, tops, dresses and skirts. The apparel will be available at specialty and department stores in the U.S. and Canada.<LicenseMag>

Hedgeye Retail’s Take: What few realize is that Simpson’s fashion company made close to $1Bn this past year and has quickly become a major brand at retail. With product across 20+ categories including shoes, jeans, swimwear, watches, and fragrance, a sportswear line is the next logical progression particularly with Jones and Camuto – both of which are current licensees of Simpson’s other lines.

 

Hermes Seeks Exemption- Hermès has filed a request with France’s market regulator AMF to be exempted from the obligation to launch an initial public offering for the company after grouping more than 50 percent of its capital into a nonlisted holding company, an Hermès spokeswoman said Tuesday. The company made the move after a family meeting last Friday to discuss how to fend off a potential takeover by LVMH Moët Hennessy Louis Vuitton, which in October surprised the market by revealing it had built a 17.1 percent stake in the maker of Birkin bags and silk scarves. Hermès subsequently clarified that the creation of the nonlisted holding company was conditional on the AMF granting it a full exemption from rules that oblige anyone crossing the threshold of a third of capital or voting rights to bid for the remaining shares on the market. <WWD>

Hedgeye Retail’s Take: Yet another chapter in the LVMH soap opera saga.  Didn’t LVMH say this was a passive investment?  Certainly seems more complicated.

 

Vera Wang to Launch Cosmetics With Kohl's - Vera Wang is making the move into cosmetics at the mass level. Kohl’s Corp., which renewed its long-term license to manufacture and market Simply Vera Vera Wang merchandise, plans to expand the brand into cosmetics by spring 2012. The branded cosmetics line will include makeup and color, skin care, bath and body products and beauty accessories, available exclusively at Kohl’s stores nationwide and kohls.com.“As part of my incredible partnership with Kohl’s, I will now be able to offer women all over America my own personal regimen for skin care and makeup,” said Wang. “It is an easy, light, modern and effortless approach to beauty and creativity. Like fashion, makeup is also transformational. I love the artistry of makeup to accentuate, enhance or create a mood for any time of day or occasion.”First licensed to Kohl’s in 2006, the Simply Vera Vera Wang lifestyle collection includes all women’s apparel, intimates and sleepwear, handbags, leather accessories, jewelry, footwear, bedding and bath. Kohl’s private brands, which accounted for 48 percent of sales in the third quarter of 2010, have become an increasingly important part of the store’s strategy. According to Kohl’s, since its launch in 2007, Simply Vera Vera Wang has consistently been a strong performer and is the leading exclusive brand in its women’s contemporary category.<WWD>

Hedgeye Retail’s Take: While a new category for Vera, this category extension (if successful) should be a nice margin enhancer to the company’s cosmetic efforts.  Already amongst the higher margin products, Wang’s private/exclusive label product is sure add some excitement to the category and Kohl’s itself.   This also marks the beginning of what we expect will be a string of announcements pertaining to exclusive merchandise distribution for 2011.

 

Men's Wearhouse Slated Big & Tall Test - The Men’s Wearhouse Inc. is the latest retailer to jump more aggressively into the big and tall business. The Houston-based firm revealed Tuesday that it will test freestanding big and tall stores, beginning with three units, under the Men’s Wearhouse name early next year. Doug Ewert, president, said the company currently has a $300 million business in extended sizes, and year-to-date growth is 40 percent higher in these categories than in the regular-size business. “We are not new to big and tall and have built this business over the last three decades,” he said. “We believe we have a strong brand among big and tall customers.” The company didn’t provide any further details about the locations or mix for the stores.  <WWD>

Hedgeye Retail’s Take: It was only a matter of time. After Casual Male’s success in testing its DXL concept in 2010 and  recent announcement to ramp doors aggressively from 4 test locations this year to 75-100 by 2015 – it looks we have another store growth race on our hands outside of sporting goods.

 

Amazon punches back at Google’s eBookstore - Yesterday Google Inc. launched a direct attack on Amazon.com’s Kindle store with the opening of the eBookstore, which sells e-books that are accessible from just about any web-enabled computer or mobile phone. And today Amazon.com punched back. Amazon, No. 1 in the Internet Retailer Top 500 Guide, today expanded Kindle for the Web to allow anyone with access to a web browser to buy and read full Kindle books without requiring a download or installation of a Kindle application. The offering previously allowed consumers to read for free first chapters of Kindle books through web browsers <Internet Retailer>

Hedgeye Retail’s Take: Another step towards an “open” system of distribution for ebooks.  Expect Barnes & Noble to follow suit.

  

Deckers Sues Emu For Infringing on Trademark - Deckers Outdoor Corporation filed a trademark infringement suit Tuesday in United States District Court in the Central District of California against Emu Australia, Inc. and Emu (Aus) Pty Ltd. Deckers is seeking a Court order to stop Emu from using its trademarks. Deckers filed a similar lawsuit against Bearpaw last month. According to Angel Martinez, Deckers Chairman and CEO, "The success of UGG Australia has created an entire industry of companies that market their wares by deliberately confusing consumers. Emu's trademark infringement is intentionally misleading consumers into believing they are buying a genuine UGG Australia product when in fact, they are not." <SportsOneSource>

Hedgeye Retail’s Take: Between recent customs support and ruling on the eBay vs. Tiffany case, the clear message to brands is that they have to support efforts to protect trademarks out of their own pocket. Deckers is leading the charge doing just that and aggressively.

 

Dior Reopens 57th Street Flagship  - With its 57th Street flagship reopening this week, Christian Dior is making the ultimate statement for all things Français.The 5,000-square-foot, two-story boutique, which was closed for five months during renovations, is returning with a complete makeover in the spirit of the iconic Dior boutique on Avenue Montaigne in Paris. The opening comes with the same amount of fanfare Dior had when it first introduced the Peter Marino-designed store concept at its landmark Paris store in 2007. LVMH Moët Hennessy Louis Vuitton chief Bernard Arnault, Dior president and chief executive officer Sidney Toledano and designer John Galliano are in town for the celebrations; the house planned two dinners; Natalie Portman will light the store facade tonight, and a cocktail party to introduce the store is expected to draw Liv Tyler, Amy Adams, Chace Crawford and Dior model Karlie Kloss. The notables at the party and dinners, as well as shoppers who will be able to see the store on Saturday when it officially opens, will find an uncompromisingly French showcase for Dior’s entire assortment, including ready-to-wear, accessories such as handbags and shoes, a separate salon for fine jewelry and special VIP rooms. <WWD>

Hedgeye Retail’s Take: Just in time for the holidays – could Dior be next on the list for LVMH’s Arnault?

 

China: October leather exports, production and shoemaking show promising growth- China’s leather exports posted a year on year increase of 38.2% in October and 33% in the first ten months, with the value reaching US$ 43.5 billion, as compared to a decrease 7.3% in the previous year. Importantly, the industry saw a growth of 27.7% in value in October, 1.7% less from previous month. The import value for the first ten months reached US$ 5.03 billion, up 36.1% year on year. <FashionNetAsia>

Hedgeye Retail’s Take: With export growth exceeding the YTD rate, but value down sequentially and wages on the rise, manufacturers are clearly getting squeezed – you can bet retailers are feeling the ripple effect as well.

 

 


Clever Enough

“The individual’s power to operate something with a deficit is very limited.”

-Ludwig von Mises

 

I think people who run their own companies (or lives) without government bailout support get this very simple point. It’s Darwinian.

 

Most modern day federal governments, however, don’t have to have any experience in the simple matter of balancing a budget. As the late Austrian economist, Ludwig von Mises, astutely pointed out, “for the government, conditions are different. The government can run a deficit, because it has the power to tax people.” (Economic Policy, von Mises’ 3rd Lecture, “Interventionism”, page 28)

 

Well what happens if a government that’s running a deficit doesn’t have the political spine to tax people? Simple answer. The risk associated with that government’s sovereign debt goes up. That’s the price of fiscal irresponsibility. Try this at home with your credit card debt and you’ll get the point.

 

Yesterday was a fascinating day in the US stock market. In risk management speak we call what happened an “outside reversal.” Essentially, outside reversals occur when some buy-and-hope event (extending the Bush tax cuts) sends US stock market futures soaring to fresh YTD highs… but then they fade intraday on heavy volume… and close below the prior YTD closing high. An outside reversal is a bearish immediate-term signal.

 

The 2010 YTD high for the SP500 is 1225. Intraday, the market registered readings as high as 1234 (on the open at 945AM EST when emotional decisions run rampant), but sold off hard into the close to settle down at 1223.

 

All the while, US Treasury yields were screaming higher. They were telling you, Mr. Shortermism of Political Career Risk Management, that CUTTING taxes when you have a massive deficit problem = sovereign debt risk.

 

So, if you are a government… and you have a debt financed deficit spending problem… and you can’t tax anyone… what do you do? This is not a trick question. There’s only one answer the Fiat Fools have for this – INFLATE.

 

In fact, it was the forefather of Big Government Intervention, John Maynard Keynes himself, who wrote in his 1936 manifesto, the General Theory of Employment, Interest and Money, that “if one devalues the currency and the workers are not clever enough to realize it, they will not offer resistance against a drop in real wage rates, as long as nominal wage rates remain the same.”

 

Sorry to Messrs Bush, Obama, and The Ber-nank. This Canadian American’s workers are Clever Enough.

 

If the ideological submission by the Keynesians is that:

  1. Markets are rational, and
  2. American workers are stupid…

I’ll comfortably sit on the common man’s side of that trade.

 

If the conclusion is that we can load American 301ks with bond fund allocations and no one will notice when they get ploughed, we’ll take the other side of that theoretical trade too. Inflation is bad for bonds.

 

Both US and Global Bond Yields are all of a sudden making a credible threat to break out into what we call a Bullish Formation (bullish on all 3 of our core investment durations: TRADE, TREND, and TAIL). The corollary to this is that sovereign bonds (including US Treasuries) are moving into a Bearish Formation. This is not what The Ber-nank ordered.

 

The following lines are the bullish intermediate-term TREND lines of support across the US Treasury Yield Curve:

  1. 2-year yields = 0.46%
  2. 10-year yield = 2.66%
  3. 30-year yields = 3.90%

In other words, bond yields are trading significantly above their intermediate-term TREND lines of support and bond funds are breaking down, hard, as a result. Maybe that’s why this morning’s ABC Consumer Confidence reading remains astonishingly low at -45 (that’s a minus 45, less than 10 points off its all-time lows) on the weekly print, despite the US stock market having a monster move of +2.9% to the upside in that week.

 

Maybe Americans don’t own as many stocks as they did when they had 401ks…

 

Maybe someone stuffed their 301ks with bond fund allocations at a bond market top…

 

Maybe Americans are Clever Enough to know what’s happening to their money when A) the government can’t tax and B) has chosen to inflate…

 

My immediate term support and resistance levels for the SP500 are now 1206 and 1239, respectively. I’ve dropped the Hedgeye Asset Allocation to Bonds to 6% in the last month and I remain short the SP500 via the SPY in the Hedgeye Portfolio.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Clever Enough - EL dec 8 chart


THE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - December 8, 2010

 

As we look at today’s set up for the S&P 500, the range is 33 points or -1.45% downside to 1206 and 1.25% upside to 1239.  Equity futures are trading mixed to fair value following Tuesday's up-and-down session which left major stock indices little changed on the day. Of note yesterday, 10 and 30 year T-bond yields hit 5-and-half month highs in reaction to the extension to tax cuts. Moody's warned that the tax cut extension, if made permanent and no offsetting measures were put in place, could put downward pressure on the US Aaa credit rating.

  • AeroVironment (AVAV) 2Q EPS 1c vs est. loss-shr 6c
  • Mitcham Industries (MIND) 3Q EPS 7c vs est. 6c
  • Men’s Wearhouse (MW) sees 4Q adj. loss-shr wider than est.
  • Netflix (NFLX) CFO Barry McCarthy to leave
  • Orexigen Therapeutics (OREX) OREX’s diet pill wins FDA panel backing
  • Starwood Property Trust (STWD) plans 20m-shr secondary
  • Texas Instruments (TXN) narrows 4Q EPS, sales forecast 
  • Costco (COST) posted 4Q EPS that beat est.

 PERFORMANCE

  • One day: Dow (0.03%), S&P 0.05%, Nasdaq +0.14%, Russell (-0.03%)
  • Year-to-date: Dow +8.93%, S&P +9.74%, Nasdaq +14.51%, Russell +22.23%
  • Sector Performance: Energy (-0.38%), Tech +0.12%, Materials +0.13%, Consumer Discretionary 0.05%, Telecom (0.03%), Industrials 0.27%, Financials 0.16%, Consumer Staples 0.56%, Utilities (0.67%), and Healthcare 0.06%

 EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: 16 (+580)  
  • VOLUME: NYSE 1622.36 (+101.88%)
  • VIX:  17.99 -0.17% YTD PERFORMANCE: -17.02%
  • SPX PUT/CALL RATIO: 1.29 from 1.32 -2.37%

CREDIT/ECONOMIC MARKET LOOK:

  • TED SPREAD: 16.93 -0.102 (-0.569%)
  • 3-MONTH T-BILL YIELD: 0.14% -0.01%  
  • YIELD CURVE: 2.61 from 2.53

COMMODITY/GROWTH EXPECTATION:

  • CRB: 315.62 -0.53%
  • Oil: 88.69 -0.77%
  • COPPER: 404.95 +1.04%
  • GOLD: 1,408.650 -0.44%

CURRENCIES:

  • EURO: 1.3302 +0.04%
  • DOLLAR: 79.857 +0.36%

OVERSEAS MARKETS:

 

EUROPEAN MARKETS:

  • European markets have fluctuated either side of unchanged in a relatively tight range after hitting their highest levels in over two years yesterday.
  • Participants assessed Ireland's austerity budget and the lack of quantitative action by EU finance ministers as worries over the regions sovereign debt crisis refuse to go away.
  • Commodity prices saw profit taking after sharp recent gains.
  • Advancing sectors lead decliners 11-7 with insurance the leading gainer, whilst personal & household products led fallers.
  • The Irish equity market is little changed, whilst peripheral markets including Spain +0.6% and Italy +0.8%, led the regions gains.
  • Bank of France Nov industry sentiment indicator 107 vs prior 104, Bank of France raises Q4 GDP forecast to +0.6% vs prior estimate +0.5%

 

ASIAN MARKTES:

  • Asian markets were mixed today.
  • Japan advanced on a softer yen.
  • Taiwan finished flat.
  • South Korea declined slightly as falls in shipbuilders outweighed gains in tech stocks.
  • Australia declined, but Aston Resources gained 5% on selling a stake in a mine to Itochu.
  • China fell on worries about higher interest rates. Railway stocks were strong on reports that the government plans to invest $600B in high-speed rail networks.
  • Chinese banks fell 2% on a belief that China will raise interest rates this weekend, and deposit rates may go up faster than lending rates do.
  • Japan October current account surplus ¥1.436T, +2.9% y/y. October machinery orders (1.4%) m/m vs (0.1%) consensus.

Howard Penney

Managing Director

 

THE DAILY OUTLOOK - levels and trends12.8

 

THE DAILY OUTLOOK - S P12.8

 

THE DAILY OUTLOOK - VIX12.8

 

THE DAILY OUTLOOK - usd12.8

 

THE DAILY OUTLOOK - oil12.8

 

THE DAILY OUTLOOK - gold12.8

 

THE DAILY OUTLOOK - copper12.8

 

 

 


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

THE CITYCENTER HURDLE

While we believe that CityCenter will succeed in getting an amendment to its credit facility, the road there should be interesting and expensive. 

 

 

Beginning in June 30, 2011, CityCenter's $1.8BN credit facilities' financial covenants will kick in and barring anything short of a miracle, they will surely not meet the current 5x maximum leverage covenant.  Almost all of the gaming amendments that we've seen over the last 18 months have involved a substantial reduction in size, an increase in interest expense, and a host of other restrictions.  Given that MGM's current credit facility restricts them from making any material ($50MM limitation) equity investments in CityCenter, and we seriously doubt that Infinity World is chomping at the bit, reducing the facility size is clearly not an option for CityCenter.  This may be a positive.

 

The other issue is that a substantial minority of the CityCenter bank debt holders are funds, which are not interested in the "relationship" or IPO fees and are therefore not as likely to play softball with MGM in the negotiation process.  We believe that CityCenter will need to find bank lenders to take out the fund holders as part of the amendment process.  This may be just one of the reasons that MGM postponed the IPO of MGM Grand Macau since they need to keep the carrot out there.  In addition to finding fresh bank capital, CityCenter may also need to make a number of other concessions to lenders to get an amendment through, including:

  • All future cash condo sale proceeds will go toward debt reduction instead of to MGM and Infinity World - not that MGM was likely to see any cash from condo sales in the foreseeable future given that that they had almost $750MM of distributions that needed to be paid out ahead of them
  • An agreement to sell the Crystals Mall over the next 18 months with proceeds going towards debt reduction
  • Potential sale of non-core assets (i.e. anything but Aria)
  • Normally, we would say an increase in interest expense, although in this case at a run rate of $60MM of EBITDA, the property is nowhere close to covering its interest expense
  • No distributions to MGM or Infinity World until leverage runs to earthly levels... basically, not anytime in the foreseeable future

In return for these and other concessions, we believe that CityCenter will get a waiver of their financial covenants and possibly another extension of the agreement which expires April 2013.

 

Bottom line, even if CityCenter EBITDA reaches $250MM over the next few years, MGM or its shareholders are unlikely to see a cent of cash from CityCenter ...paper profits will have to suffice.


REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE

Revolving Consumer Credit Still Sinking, but Nonrevolving Credit Shows Growth

 

Just-released October G.19 data showed another decline in revolving credit, along with significant downward revisions to earlier data points.  G.19 measures non-mortgage consumer credit: credit card, auto and student loan debt.  While the month-over-month decline in revolving credit was not as severe as the September print (-13.0%, revised down from -12.1%), it remains far from healthy. Revolving credit (i.e. card debt), the piece we are most focused on, fell -8.4% (MoM annualized) to $800B.  Currently, the peak to trough decline in revolving consumer credit stands at -17.8%, or $173B.

 

The ongoing deleveraging by the consumer is alive and well. Contrary to media reports that the principal driver of deleveraging is actually charge-offs, charge-offs represent less than half of the deleveraging that we've seen in consumer credit to date. This marks the 25th consecutive month in which aggregate credit card debt has declined.  Prior to this contraction, the longest drawdown in consumer revolving credit lasted just five months.   

 

Nonrevolving credit (auto and student loans) rose 6.8% in October vs +7.6% in September (revised from +7.9%).  With the strength from nonrevolving credit leading the way, overall nonmortgage credit increased for the second month in a row, rising 1.7% (MoM annualized).

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j1

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j2

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j3

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j4

 

 

Overall bank loans have declined 12% since the peak in late 2008, as seen below in the H.8 series. 

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j5

 

 

The Financials with the greatest exposure to credit card receivables are shown below, including JPMorgan (JPM), Bank of America (BAC), Citigroup (C), American Express (AXP), Capital One (COF), and Discover (DFS).

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j6

 

 

Overall, total non-mortgage credit increased 1.7%, or $3.4B, as shown in the following charts.

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j7

 

REVOLVING CONSUMER CREDIT DATA SHOWS YET ANOTHER DECLINE - j8

 

 

Joshua Steiner, CFA

 

Allison Kaptur

 

 

 

 

 


GETTING PUNCHED IN THE FACE

This note was originally published at 8am this morning, December 07, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Everyone has a plan 'till they get punched in the mouth.”
- Mike Tyson

 

There have been a lot of interesting Mike Tyson quotes over the years, some fit for print, others less so, but this one seems apropos for the times. The Fed tells us they have a plan, and they’re implementing it. So far, the markets seem to like it. Let’s see how their plan fares once they get punched in the mouth.

 

This summer we introduced our bearish thesis on housing with our 100-page report entitled: “How Low Will Housing Go in 2H10 and 2011”. In that report we laid out our three separate home price models: our supply model, our demand model, and our combination supply & demand model. The output of those models forecast home price declines ranging from high single digits to 20%+ over the next 12-18 months. How have we fared so far? As the chart at the end of this note shows, the four major home price series that we track (Case-Shiller 20 City, Corelogic, FHFA, and Existing Home Sales Median Home Price) are all heading south. After peaking in the April/May timeframe on the strength of the tax credit, three out of four home price series are now solidly in negative year-over-year territory. The lone holdout, Case-Shiller, is a 3-month rolling average, which is why it lags the other series in reflecting the degree of slowdown. The next few months of Case-Shiller data will show a comparable negative trend.

 

For reference, the Corelogic series is the series now used by the Federal Reserve. How has the Fed’s preferred series fared? According to Corelogic, home prices have rolled from being up +4.3% YoY in May 2010 to being down -2.8% YoY in September 2010, a negative -7.1% swing in four months. Looking month-over-month, the Corelogic series was down -1.8% sequentially in September (the most recent data available), which translates to the fastest rate of decline since February 2009.

 

The supply and demand imbalances were at the root of our housing call this past summer and nothing has changed on that front. The market is more dislocated today than it was when we made the call in the summer. At the time we made our call in June there were 3.99 million homes on the market for sale and existing home sales were running at a rate of 5.37 million, which equated to 8.9 months of supply. Today, there are 3.86 million home on the market for sale (October), while existing home sales are running at a rate of 4.43 million, which equates to 10.5 months of supply. Existing home inventory peaked at 12.5 months of supply in July. Based on our conclusion that home prices take one year to fully respond to supply and demand imbalances, we would expect to see July 2011 be the low watermark for year-over-year price trends in housing. The more important takeaway, however, is that between now and July 2011 the trends should continue to get worse. While it is possible that the market’s “bad news is good news” mentality will persist and ongoing weakening in home prices will simply translate into greater and greater expectations for further quantitative easing, we continue to think that bad news is simply bad.

 

Another point to consider is the impact QE2 is having on the housing market. While recent demand statistics have been modestly upbeat (i.e. October pending home sales up 10.4% month-over-month), the reality is that mortgage rates have backed up sharply in November. The Bankrate 30-year conforming mortgage index has ballooned from 4.20% a month ago to 4.70% yesterday. For reference, a 50 bp backup in 30-year rates has a 5% negative effect on affordability.

 

It’s also worth pointing out that no amount of stimulus or quantitative easing seems to increase banks’ willingness to underwrite residential mortgage loans. In the most recent Senior Loan Officer Survey released November 8, the net percentage of lenders tightening access to prime mortgage credit rose to +9.3% from -5.5% quarter over quarter meaning that the average American is now finding it more difficult to get a mortgage than they were over the summer. The trend was similar for access to nontraditional mortgage credit: +9.5% of respondents reported tightening standards, up from +4.5% last quarter. This isn’t helped by the fact that banks are currently engaged in trench warfare with Fannie & Freddie as well as the entire private-label MBS universe over mortgage putbacks. Further, there are 8.5 million borrowers who have either been foreclosed or are currently non-performing on their loan. This is a large slice of the overall homeownership pie that has been semi-permanently eliminated from the buyer pool (7 years for most lenders to look past a mortgage default). All of this has cast a pall over banks’ willingness to underwrite new mortgages.

 

Many investors forget just how slippery the slope of negative home prices can be. Falling prices don’t happen in a vacuum: they have two insidious offshoots. First, they generate a tangible negative wealth effect. For reference, for all the excitement resulting from the upward move in equities recently, consider that as a rough rule of thumb, every 100 points of upside in the S&P is roughly equivalent to a 5-6% rise in home prices based on there being total direct equity wealth of $10.8 trillion and total residential housing wealth of $17.1 trillion. That said, the wealth associated with housing is much more broadly felt as 65% of American families are homeowners, a far higher proportion than those with material equity wealth. Second, negative home price trends increase pools of underwater borrowers. We have shown that there are presently 11.3 million borrowers (20% of all borrowers) who are underwater. 4.9 million of whom are underwater by more than 25%. A 20% decline in home prices from here would increase those who are underwater to 21.9 million (46% of all borrowers) and those underwater by 25% or more would rise to 9.4 million (20% of all borrowers). Laurie Goodman, a Senior Managing Director with Amherst Securities, one of the leading providers of mortgage data analytics, has shown that loans with LTVs greater than 120% are currently defaulting at an annualized rate of 19.1%, while those with LTVs between 100-120% are defaulting at an annualized rate of 11.3%. Those are scary statistics when one considers that there could be 22 million borrowers in a negative equity position with a 20% drop in home prices from here.

 

The real question is, what will a 20% drop in home prices feel like for the markets and for the consumer? Our guess is that it will feel a lot like getting punched in the face by Mike Tyson.

 

Josh Steiner

Managing Director

 

GETTING PUNCHED IN THE FACE - early look home price compendium


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