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EARLY LOOK: The Cliffs of Insanity

“All truths are easy to understand once they are discovered; the point is to discover them.”
- Galileo Galilei

 

The penalties for non-consensus thinking were harsher 400 years ago. In 1610 Galileo published his observational studies of the moons of Jupiter as evidence in support of Copernicanism and a heliocentric model of the solar system. At the time, most astronomers still believed in a geocentric model and considered a heliocentric model outrageous. Galileo’s work was derided by many of his contemporaries and, ultimately, Galileo was brought before the Roman Inquisition for heresy, tried, found guilty and forced to spend the rest of his life under house arrest.

 

Fortunately in today’s world the penalties for having a non-consensus view generally aren’t as severe. That said, it can still take a long time for certain entrenched assumptions to change and evolve, which brings us to the subject of today’s Early Look. One such entrenched assumption in the investment community today is that home prices are unlikely to fall materially from here.

 

For those unfamiliar, our view on housing is bearish and our argument relies principally on supply and demand data, and the imbalances that exist between them. Our analysis has sought to both measure and quantify the effects of dislocations in supply and demand in housing and the lagged effects these imbalances have on home prices. Our conclusion is that based on the current supply and demand imbalance, prices will be 15-20% lower in 12-18 months on a national basis. This is an overly simplistic summary of a 100+ page presentation we’ve assembled on the subject, but below we present just a few of the facts worth considering.

 

Consider the following. There are currently 3.99 million homes on the market for sale as of the end of June. Existing home sales were 5.37 million (seasonally adjusted annualized rate) in June, which equates to 8.9 months of supply. This is disingenuous, however, as June existing home sales represent April contract activity. We know that post-April pending homes sales are down over 30% through May and June. As such, we would expect a comparable decline in existing home sales once the data rolls through on a lag later this month. In other words, existing home sales for July/August will be in the ~4 million range, which will be a wake-up call to the Panglossian bulls. Assuming inventory remains around 4 million this will equate to ~12 months of supply. The market is often considered in equilibrium when inventory is 5-6 months of supply. For reference, 12 months will be the highest amount of supply seen since the housing downturn began. This 12 months figure does not include shadow inventory, which likely represents an additional 4.2 to 6.0 million homes (according to estimates from the Mortgage Bankers Association, the Federal Government’s HAMP Program, and Lender Processing Services, the largest mortgage default processor in the country.)

 

Laurie Goodman, a Senior Managing Director with Amherst Securities, one of the leading providers of mortgage data analytics, recently published a paper in the Financial Analysts Journal entitled “Dimensioning the Housing Crisis” in which she submits that from the beginning of the crisis (YE06) through today there have been 1.5 million homes liquidated through foreclosure and short sale. During this timeframe, depending on which housing series you use, home prices have fallen 20-35% nationally. Using conservative assumptions, she concludes that a further 11-12 million homes will be liquidated in coming years. If 1.5 million liquidations coupled with broader supply/demand imbalances triggered 20-35% downside in home prices, consider what 11-12mn liquidations will do amid a more severe underlying supply/demand imbalance.

 

While the government has intervened over the past 18 months to try and arrest the rate of decline in home prices, we think their efforts have merely kicked the can down the road and have done little to alter the underlying nature of the problem. Ultimately, the pressure from foreclosures will outstrip the government’s ability to hold back the supply.

 

Touching briefly on the demand side of the equation, demand for mortgages as measured by the MBA Purchase Index has been steadily falling for the last five years. After averaging 471 in 2005, the Purchase Index fell to 264 in 2009 (-44%). 2010 to date is down to 209 (-55%). The month of July averaged just 170, a 64% decline from 2005. For reference, 2010 year-to-date demand is consistent with demand last seen in 1997-1998, while July demand is consistent with levels last seen in 1995.

 

It seems obvious to us that home prices are headed materially lower from here, yet many people – most in fact – don’t agree. There are a host of reasons we’ve had explained to us why home prices shouldn’t go down from here. The most oft-cited is the demographics argument, namely that there should be solid net new household formation over the next several years that will drive marginal demand for homes high enough to absorb existing supply, shadow inventory and whatever other pressures might come down the road.

 

It’s foolish to dismiss criticism out of hand without first thinking it through – especially when multiple investors are telling you the same thing. To that end, we’ve analyzed the core of the argument that household formation is set to take off, and what we’ve found is quite interesting. The chart at the end of this report shows data that we don’t think many people are aware exists. It represents real household formation rates through June 2010. We have the data monthly – not many people do. What is striking is that it shows that in the first half of 2010 the number of households in the US actually shrank. This is the first time this has happened since the data series began, and our data goes back to the 1950s. Moreover, negative growth in 1H10 follows anemic growth in 2008 and 2009.

 

Why is this? Normally, some 60% of net new household formation occurs in the 20-29 year old demographic. It’s typically at this age when a young person moves away from home and, in doing so, a new household is created. The catch is that unemployment is at 9.5% nationally, and the unemployment rate for this age cohort is well into the teens. Remember, household formation is a derivative of confidence, which itself is merely an extension of the employment environment. This lack of confidence must be having a profound effect across the country for the number of households to actually be shrinking.

 

Will this change? The relationship between the economy and household formation is reflexive, to borrow a philosophical concept from George Soros. That is to say, when times are good household formation drives the economy amid a virtuous cycle, but when times are bad the economy will suppress household formation, which, in turn, feeds back negatively into the economy in a vicious cycle. The latter is the dynamic that exists today.

 

Our firm is of the strong view that US economic growth is poised to decelerate meaningfully in the back half of the year and into 2011, which will keep a lid on hiring. This will in turn keep the lid on household formation, the one credible case for a pick-up in housing demand.

 

Josh Steiner
Managing Director

 

EARLY LOOK: The Cliffs of Insanity - JSEL


EARLY LOOK: Don't Do Dogma

 “And remember, no matter where you go, there you are.”
-Confucius

I’ve learned, un-learned, a re-learned this lesson in trading markets many times in the last decade  - Don’t Do Dogma. The larger your risk management and research team becomes, the harder it gets to adhere to that discipline. The more research edge you have, the more confident you tend to become. This breeds confirmation bias and risk.
 
A disciplined risk management approach to allocating capital is a process best learned by doing. I don’t learn much when my team is right on the research - I work with winners who wakeup expecting to be right. I learn the most when our positioning to express that research is wrong.
 
This gets to the heart of a structural problem with our industry. There is a huge difference between being right on the research and right on your timing, sizing, and positioning. Our industry pays a “star” premium for conviction in best research “ideas”, but pays much less for the risk managed expression of those ideas. This is good. It provides a tremendous opportunity for us to evolve our profession.
 
“No matter where you go” this morning, “there you are.” I have my coffee and my notebook, and markets are trading for and against my positioning. Without a repeatable risk management plan, I’m not sure what you do when you login every morning. Different strokes for different folks, I guess, but when it comes to grinding through the morning’s macro data, my research process has a very low standard deviation.
 
Conversely, as you may have noticed, my decision making process has a very high standard deviation. Sometimes I make too many Hedgeye Virtual Portfolio and Asset Allocation moves, sometimes I make too few. I learned this playing hockey more than anything else, but there is a time to be moving your feet, and there is a time to wait in the weeds – goals get scored when your timing is right.
 
Yesterday the US stock market was down, so I took that as an opportunity to cover some shorts and buy some longs. Because our macro research is bearish on both the US Dollar and the SP500 doesn’t mean I have to be bearish at every time and price on everything USA (we’re long XLU, Utilities).
 
In modern day risk management, it’s critical to contextualize both time and price within the framework of different investment durations. That’s why we have developed the TRADE, TREND, and TAIL process. It helps us communicate our research findings in a way that isn’t Duration Dogmatic.

The SP500 has only had 1 up day in the last 6 trading days. That 1 up day was of consequence however, because it took out the immediate term TRADE line of resistance of 1117. Whenever resistance becomes support on any of our 3 core investment durations (TRADE, TREND, and TAIL), I start moving my feet.
 
The setup for this morning is the same as it was as I was changing my positioning into yesterday’s close. Inactive investors dogmatically call this “trading” – I call it proactively managing risk. You trade today in order to set yourself up for tomorrow.
 
We went through this on our Macro Monthly Strategy conference call yesterday (if you’d like the slides and replay, please email sales@hedgeye.com <mailto:sales@hedgeye.com> ), but it’s worth repeating – the Bear Market Macro lines for the US Dollar Index and SP500 are $84.32 and 1144, respectively. These are my intermediate term TREND lines of resistance. These back-test with the highest success rate of any duration in my model.
 
Bearish TREND doesn’t always mean bearish TRADE. To the contrary, bearish TREND often insulates bullish trading inasmuch as bullish TREND formations can perpetuate bearish immediate term trading. Bull and bear markets get both overbought and oversold.
 
If the US stock market gets banged up today, there are no rules saying that this bullish immediate term TRADE support line of 1117 in the SP500 can’t become resistance again - and quickly, with no downside support to 1089. Don’t get frustrated with how short term that sounds. Embrace it. Managing risk doesn’t occur in a baby blue Tiffany box.
 
The conclusion of all this is always on the tape. Yesterday I invested 6% of the Cash position in our Asset Allocation model, taking Cash down from 79% to 73% by adding a long position in International Equities - Indonesia (IDX) – and adding another 3% to our long position in the Chinese Yuan (CYB).
 
The risk in all of this is that 1117 doesn’t hold, because that means anything I covered or bought yesterday will have likely been executed on too early. In real life investing, being too early means being wrong. Don’t Do Dogma – that’s for marketing presentations about investing.

Best of luck out there today,
KM

 

EARLY LOOK: Don't Do Dogma - dont do dogma


EARLY LOOK: Enslaving America

 

"There are two ways to conquer and enslave a nation. One is by the sword. The other is by debt."
-John Adams, US President
 
Yesterday was another great day for our short position in the US Dollar. It was a terrible day for our short position in the SP500. As perverse as this may sound, both the US stock and bond markets all of a sudden love the idea of America losing its status as the world’s reserve currency as we enslave our citizenry with debt.
 
The sad news is that despite both America and Japan resorting to “quantitative easing” in the recent past, some professional politicians in this country have learned nothing from these mistakes. So if you have any American friends who get all amped up and cheer the stock market on when they hear “rumors of QE2”, please take a step back, take a deep breath, and tell them to be careful of what they hope for.
 
Hope, of course, is not an investment process. Hope is not going to make America’s debt and deficit problems go away. Neither will the Paul Krugman type fear-mongering that got both the US and Japan in this mess to begin with. Before the internet, dinosaurs, and YouTube, Krugman’s fear-based model provided the false premise that no one would hold him accountable to his recommendations. No matter where the Krugmanites go, here it is:
 
“So never mind those long lists of reasons for Japan’s slump. The answer to the country’s immediate problems is simple: PRINT LOTS OF MONEY.”
-Paul Krugman (1997)
 
To be balanced, it appears that by 2006 when he penned an Op-Ed titled “Debt and Denial”, Krugman showed some evolution in his thought process:
 
“But serious analysts know that America’s borrowing binge is unsustainable. Sooner or later the trade deficit will have to come down, the housing boom will have to end, and both American consumers and the US government will have to start living within their means.”
-Paul Krugman (2006)
 
Sadly, now that it’s 2010 it’s clear that Krugman has forgotten the fiscal discipline he mustered while he was Bush-bashing the double edged sword of deficits and debt. He’s right back to his 1997 form in recommending that his Princeton pal Heli-Ben Bernanke “prints lots of money.”
 
Much like Nassim Taleb did in taking the puck right to the net on another Fiat Republic alum from Princeton in the Huffington Post last night (“The Regulator Franchise – Or the Alan Blinder Problem”), at 11AM EST today, my defense partner, Daryl Jones (aka Big Alberta) will be joined by our macro team here in New Haven, CT taking the Krugmanites and monetarists alike to task.
 
As much fun as we like to have calling people out (including ourselves), this time it’s game time. We’re dropping the mitts with those debt and deficit sponsors who are putting this country’s national wealth and security at risk.
The primary implication from our conference call will have to do with our #1 concern versus consensus right now – US economic growth. A build-up in debt on the federal balance sheet proactively predicts a dramatically different future as it relates to the underlying growth in America.  If the last 200 years of data has shown us anything, it is simply that those nations with high debt balances either default or grow well below mean rates of economic growth as long as debt ratios remain high.

We’ll have 45 slides of hard data and forecasts today. We also have a 101 slide presentation titled “Housing Headwinds” that our Financials team, led by Josh Steiner, has compiled to back up the embedded conclusions we are making about US GDP growth; namely that US Housing prices could drop -15-20% from this summer’s bear market cycle-peak in the Case-Shiller Index. Here are the details for the call:

 


"Should U.S. Government Debt Be Rated Junk Status?"

Key topics to be discussed:

  • The implications for the U.S. economy of the massive build up of debt
  • Various federal budget scenarios and their key drivers
  • GDP growth implications based on accelerating debt balances
  • Implications to the deficit under different interest rate regimes
  • Comparison of the U.S. to the PIIGS on key ratios
  • Appropriate investment vehicles for this long-term TAIL theme



If you would like to reserve a spot on the call, please email sales@hedgeye.com. <mailto:sales@hedgeye.com>

Back to today’s risk management setup. We got a lot of questions yesterday as to when/where I was a short seller of the SP500 (SPY). Once the SP500 broke out above my immediate term TRADE line of resistance (1118) yesterday, that resistance level became very short term support – so I watched and waited. I’d like to short the SP500 from 1133 all the way up to my Bear Market Macro line of 1144. For now, that’s the plan.

For any modern day Risk Manager of real-time market prices, the plan needs to be that the plan is going to change. We’ve been bearish on the US stock market since April and bearish on the US Dollar since June. I may have missed half of the bear market bounce that the SP500 has had since its July 2nd low, but I don’t intend on missing this next selling opportunity as we enter the most critical stage of professional politicians Enslaving America with debt.

We didn’t sell everything yesterday in the Hedgeye Asset Allocation Model, but we took our cash position back up to our highest level of 2010 at 79% (up from 58% Cash on July 2nd when the SP500 bottomed at 1022).

Best of luck out there today,

KM

 

EARLY LOOK: Enslaving America - el3


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EARLY LOOK: Discounting The Obvious

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”
-George Soros
 
Before I went to bed last night, China reported another sequential deceleration in its manufacturing PMI Index for the month of July. I thought to myself – wow, that explains absolutely nothing in terms of how both oil and copper have been trading for the last 3 weeks (UP). However, it explains everything in terms of why Chinese stocks have underperformed global equities for the last 7 months (DOWN). China has slowed.
 
In Q1 we called this the Chinese Ox In A Box. In our Q1 slide presentation we even had a fancy looking Hedgeye Macro Theme chart that outlined the forecast that PMI readings in the high 50’s were unsustainable given that the Chinese were going to tighten.
 
So China tightened… and now the PMI reading has dropped -12% over the course of 6 months into the low 50’s (July’s reading was 51.2% versus 52.1% in June)… and next to Slovakia and Greece, the Chinese stock market is the worst performing in the world for the year-to-date.
 
That, however, doesn’t mean that in the face of a monster 2-month rally in European equities (i.e. the other worst performing stock markets for the YTD – Greece, Spain, etc.) that Chinese stocks don’t have every opportunity to A) mean-revert to the upside alongside global equities or B) show you that they have already Discounted The Obvious.
 
On the heels of this “bearish” economic data last night, China closed up another +1.3% to 2672 on the Shanghai Composite Exchange, taking its rally from its YTD low established on July 5, 2010 to +13.5%. Chinese equities are up basically in a straight line – closing up on 9 out of its last 11 trading days.
 
So what do you do with that? Inclusive of this rally, the Shanghai Composite Index is still -18.5% YTD. Economic growth is still slowing, but everything that slows finds a time and a price where it gets baked into the Mr. Macro’s cake. Should you chase it here? Should you short it? Should you do nothing?
 
Whenever I miss a big move like this, I tend to try my best to do nothing. Particularly if the math in my TRADE versus TREND model isn’t yet clarifying the risk management decision for me. Here are our TRADE, TREND, and TAIL lines for the Shanghai Composite Exchange:
 
1.      TRADE = bullish, with 2491 support

2.      TREND = bearish, with 2693, resistance

3.      TAIL = bearish, with 2988, resistance

 
Since the Shanghai Composite closed at 2672 last night, you’ll notice that it’s game time now for the intermediate term TREND in Chinese equities. We’re either at an inflection point where price momentum is making the turn from bearish to bullish, or we’re right where the long term bearish case for Chinese stocks fortifies itself.
 
Since I don’t have a long or short position in China right now other than long the Chinese Yuan (CYB), I don’t feel compelled to make a “call” on which way this is going to go. I’m much more comfortable letting the macro math tell me what to do. Chinese growth has every opportunity to re-accelerate from here, but it could just as easily continue to slow. The big money on the short side has already been made.
 
Looking at a multi-factor global macro model for the answer is also going to be critical here. Let’s consider some critical signals relative to the summer of 2008:
 
1.      Dr. Copper

2.      US Dollar

3.      Gold

 
Both the prices of copper and gold are all of a sudden doing what they did at the end of July and early August of 2008. Much like it is doing now, the US Dollar was getting creamed (down for the 8th consecutive week last week, taking the USD down -8% since early June) and all of a sudden the “reflation” trade in gold decoupled from that in copper (DOLLAR DOWN equaled copper up, but gold down and a lot of people couldn’t figure out why).
 
Chinese equities also based and rallied in July of 2008, but that was a sucker’s rally in as much as it was in Copper. Gold and the US Dollar were actually leading indicators for almost everything else going down back then. I don’t see that same setup right here and now, but “betting on the unexpected” can pay the bills. Food for thought on a Monday while we’re all Discounting The Obvious of the China slowdown that’s in our rear-view.
 
My immediate term support and resistance levels for the SP500 are now 1076 and 1118, respectively. The SP500 hasn’t had an up day in the last 4, so we took midday weakness in US equity trading on Friday as a buying opportunity, moving our allocation to US Equities from zero up to 3%.
 
Best of luck out there today,
KM

 

EARLY LOOK: Discounting The Obvious - cHH


MACRO: INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS

Jobs, Jobs, Jobs .... Still No Signs of Progress


Initial claims rose by 19k last week to 479k (rising 22k net of the revision).  Rolling claims came in at 458.5k, a rise of 5.25k over the previous week. This is the largest increase in the rolling series since early April, but it still remains in the range of 450-470k that it has occupied for all of 2010. Ultimately, we are still looking for initial claims in the 375-400k range before unemployment meaningfully improves.
 
Our firm is of the strong view that US economic growth is going to slow markedly in the back half of this year and into 2011. We think this will keep a lid on new hiring activity and will keep cost rationalization paramount in the minds of C-suite executives. All of this raises the risks that a prospective slowdown in GDP will precipitate an incremental slowdown in hiring/pickup in firings, which will, in turn, further pressure growth. We continue to look to claims as the best indicator for the job market, as they are real time and inflections in the series have signaled important turning points in the market in the past.

 

MACRO: INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS - macro ch1

 

MACRO: INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS - macro ch2

 

Joshua Steiner

Managing Director, Financials

 

***As a reminder, May was the peak month of Census hiring, and it will remain a headwind through the September data as the Census continues to wind down.

 

MACRO: INITIAL CLAIMS RISE 19K - NO SIGNS OF PROGRESS - macro ch3


MACRO: THE FUTURE OF THE U.S. BALANCE SHEET

Tomorrow at 11 a.m. eastern we will be hosting our August Theme call, titled: “Should U.S. Government Debt Be Rated Junk Status?”  The intention of the title is not to suggest literally that U.S. government debt should be rated junk status, but rather to raise a serious red flag as to the emerging deficit and debt problem in the United States and the investment implications therein.  If you would like to join the call, please email sales@hedgeye.com.
 
In the chart below, which is sourced from the Congressional Budget Office, the fiscal future of the United States is portrayed based on longer term budget projections.  The CBO provides two scenarios for budget projections.  In either scenario, the balance sheet of the United States sees a continued build-up of debt for the ensuing two decades.  In the more negative scenario, debt as a percentage of GDP accelerates dramatically over the coming decades, eventually approaching near 200%.
 
As we will discuss in greater detail tomorrow, the primary implication of a build-up in debt on the federal balance sheet is a dramatically different future as it relates to underlying growth.  If the last 200 years of data has shown us anything, it is simply that those nations with high debt balances either default or grow well below mean rates as long as debt ratios remain high.
 
We, of course, aren’t suggesting that the U.S. is bound to default anytime soon, but there are implications of an accelerating U.S. debt balance that we need to keep front and center.  One longer term consideration is simply that investors, both domestically and abroad, begin to lose confidence in U.S. government debt particularly at the current all-time low interest rates.  An increase in interest rates has meaningful implications for the U.S. budget.  According to a paper from the CBO today titled, “Federal Debt and the Risk of a Fiscal Crisis”, a 4-percentage across the board increase in interest rates would raise interest rate payments by more than $100 billion on an annualized basis.
 
A conclusion of our analysis tomorrow will be that the future will look much different than the most recent past in terms of the economic outlook of the United States over the coming years.  And the reality is, as debt grows and confidence wanes, the likelihood of a fiscal crisis of some magnitude grows.  In that scenario, as the CBO also wrote today, there are three primary prescriptions for the United States:
 
“restructuring its debt (that is, seeking to modify the contractual terms of existing obligations); pursuing inflationary monetary policy (that is, increasing the supply of money); and adopting an austerity program of spending cuts and tax increases.”
 
Is a fiscal crisis in the United States imminent? Perhaps not, but the future of the U.S. government balance sheet is bleak based any reasonable federal government budgetary assumptions.  We hope you can join us for the discussion tomorrow at 11 a.m. eastern.
 
Daryl G. Jones
Managing Director

 

MACRO: THE FUTURE OF THE U.S. BALANCE SHEET - future of us balance


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