Eigen-housing

“When rates aren’t moving they don’t really matter to housing. But when they are moving they are all that matters.”
- Josh Steiner, @HedgeyeFIG

As complexity adherents, we invariably harbor an affinity for process that attempts to simplify the complex.

In linear algebra/data science/machine learning, eigenvectors serve as a basis for dimensionality reduction and the simplification of otherwise complex linear transformations. 

What does that mean? ….. pre-caffeine, early on a Tuesday morning. 

Eigen is a German word most usefully translated as “characteristic” and eigen-ness describes the vectors or properties that are characteristic to a particular space. 

In our everyday experience, vectors are mostly closely associated with physical phenomenon …. representing movement along the x and y axis or within 3-dimensional space. 

But vectors and matrices (sets of vectors) can be abstracted to n-dimensional space and that “space” doesn’t have to represent physical space. 

More broadly, it can simply be thought of as “data space” with each parameter/input adding a new dimension to the set.   Representing this graphically or geometrically quickly becomes intractable once you move beyond 3 dimensions.  But the idea is still the same.   

For our purposes, eigen-bases serve a selection of functions.  Definitionally, they represent the most efficient basis to describe variability in a set of data. Practically, they work to decompose/decouple dependent systems, so the impact of different components can be analyzed independently.  Conceptually, they help filter out redundant information, isolating the components principally responsible in describing a particular phenomenon.  

Less noise, more signal.  A mathematical approach discretely aimed at simplifying the complex.

There are, of course, limitations and pitfalls but, as a generalized approach, what’s not to like?

Back to the Global Macro Grind ….

Last Friday we hosted our 4Q Housing themes call. We walked through a 130-page analytical tome that comprehensively contextualized prevailing conditions across pretty much every dimension of the domestic residential housing market.

The truth, however, is that, at times, the dimensionality of housing investment collapses to a single vector whose direction and magnitude is easily observable and measurable. 

To quote my partner and @Hedgeye housing sage, Josh Steiner:

“When rates aren’t moving they don’t really matter to housing. But when they are moving they are all that matters.”  #Eigen-Steiner

When you can articulate an entire investment thesis in less than 90 seconds and capture its crux in just a couple visuals, it’s hard to not feel like you’re missing something.

I suppose there is a lot of work on the front end to build a conceptual and analytical framework capable of distilling a given condition set to a simple investible conclusion but, at times, because “Quad 4 and rates” doesn’t always ‘feel’ like premium institutional level research. 

Fortunately, we don’t do “feel” as part of the process …. although +51% YTD (+33% relative) ‘feels’ pretty good. 

To bring our view up to date, here’s the summary describing the evolution of the housing call since this time last year and how we see the nearer-term setup:  

The Macro (evolution from the U.S. cycle peak in 3Q18 -> present):

1. The tail end of the longest acceleration in domestic growth ever and an (associated) over-hawkish fed drive interest rates higher in 2018. A dynamic which gave way to ….  
2. Global Quad 4 --> rates ↓
3. Developing Domestic Quad 4 --> rates ↓
4. Slowing Headline Growth domestically accompanied by late-cycle labor dynamics, rising wage growth, a rising share of national income to labor and flat’ish growth in household consumption capacity = housing consumption positive

The Fundamentals:

1. Supply tightness in the existing market acting as an ongoing and increasing constraint to transaction volume growth
2. Twin rate shocks in 2018 (1Q and into 4Q)
3. A 4Q18 crescendo in growth angst related to the more conspicuous emergence of Quad 4 conditions described above
4. (1+2+3) conspired to crater demand growth in 4Q18 and into 1Q19, creating one of the most favorable base effect setups in all of macro in 4Q19.  

Sentiment: 

1. The Housing Surprise Index hit an all-time low in December 2018 (a time series which includes the financial crisis!)
2. Builder Valuation – forward P/E and P/TB – tapped the bottom of the prior 5Y range into 2019.
3. Builders (almost all the liquid “housing” etfs are builder centric) fell by -33% in 2018.

So, coming into 2019, Housing fundamentals were in raging dumpster fire formation, housing related equities had dramatically underperformed and Housing sentiment was completely washed out. 

But the Quad 4 outlook was for rates to fall and, absent outright recession, Quad 4 is positive for Housing performance with rates as the causal factor.  Importantly, we weren’t making a recession call, our near-term outlook on the consumption side was “steady as she goes” and the 2H18 collapse would progressively become the comp. 

As far as macro-centric sector theses go, that’s about as simple as it gets.  And contrary to investors’ inherent proclivity for sophistication, ‘simple’ is still not a synonym for ‘wrong’.   The Chart-of-the-Day Trifecta below simplifies it, visually.

Looking Ahead: 

• Nearer-term, the setup described above remains largely in place.  We’ve seen organic improvement in the housing market with support from improved affordability (slowing HPI and lower rates) and the reported rate-of-change reality will remain solid as we traverse the trough Oct-Feb comps. 
• Is the setup as compelling as it was a year ago?  No, but ….
• We should get almost 2 more full quarters of strong data which will be occurring during the seasonally strong period (4Q/1Q) for housing returns.  Indeed, housing demand metrics are likely to be up high-single, low double digits over the next few months … compelling when juxtaposed against a 3Q19 earnings season characterized by broadly negative EPS growth and high-frequency cyclical data mired in outright contraction.     
• Frequentist Fodder:  Strong positive performance doesn’t portend an acute hangover in the subsequent year.  In fact, years of strong positive performance have been followed by another year positive, but less positive, performance in each instance over the last 20 years with the exception of 2018. 

Tracking the Turn:

• As we move past 4Q19 and through 1Q20, the base effect and seasonality tailwinds recede.  Removal or lack of a positive can sometimes be the same thing as a negative. 
• Rates:  Rates aren’t always the enemy.  To the extent interest rates increase at a measured pace and are a reflection of improving strength and momentum in the macro environment, it can be taken as a positive.  The concurrent increase in interest rates and strong builder performance in 2017 is a good case study in that.  However, ….
• Quad Outlook:  To the extent we move more conspicuously into Quad 2 or Quad 3 it well serve as an increasing headwind to housing, particularly as we move past the comp and seasonality catalysts.   Quads 2/3 haven’t been particularly favorable for housing related equity performance.
• Conforming loan standards appear to be tightening under new FHFA Director Calabria. Ongoing tightening could pressure access to capital.
• Sentiment and valuations are now approaching trailing 5-year highs.  Valuation isn’t a catalyst but richness and off-sides sentiment do serve as reflexive amplifiers once the cycle tide turns. 

One for the road:  Now that we’ve got you all bull’d up, today’s EHS data is likely to reflect sequential softness.  Given the trend in signed contract activity, closed transaction volume in August will likely be down M/M and is unlikely to contribute to further upside in HIS (Housing Surprise Index).

In short, housing has been dead nuts in 2019 and is set to remain plumb, level and square the next few months.   

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND signals in brackets) are now: 

UST 10yr Yield 1.55-1.85% (bearish)
SPX 2 (bullish)
NASDAQ 7 (bearish)
Utilities (XLU) 63.17-64.61 (bullish)
REITS (VNQ) 92.20-96.10 (bullish)
Energy (XLE) 55.40-58.78 (neutral)
USD 96.58-98.17 (neutral)
Oil (WTI) 52.08-54.92 (bearish)
Gold 1 (bullish)
Copper 2.54-2.66 (bearish)

Best of luck out there,

Christian B. Drake