I’ve mentioned before how all of my old articles at RealMoney were lost. This was the draft version of Real Estate’s Top Looms published on 05/20/05. I followed it up with Housing Bubblettes, Redux on 10/27/05 and September 2005 — The Residential Real Estate Inflection Point on 02/14/06. Also, there was Wrecking Ball Looms for Big Housing Spec on 11/27/06, where I explained why it was likely that the subprime residential mortgage market was likely to blow up (can’t find the draft of that one).
But those links above no longer work — a real pity, and the one link below is corrected to point to the republished article at my blog. Anyway, enjoy this if you want, because it outlines my thinking on how to recognize whether you are getting near the end of the bull phase of a market.
(Note: the italicized, indented portions, quote the original article The Fundamentals of Market Tops. Much of what I write compares how residential real estate is similar to and different from stocks.)
On April 9th 2021, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. Q1 2021 hedge fund letters, conferences and more Read More
About a year and a half ago, I wrote a piece called The Fundamentals of Market Tops. It was an important piece for me because I received a lot of positive feedback from readers. It was also important because it disagreed with the view of the firm that I worked for, and nearly led to my termination there, because they encouraged me to stop writing for RealMoney. Neither termination happened, but it was touch-and-go for a while.
This piece unofficially represents the views of the firm that I work for, because my views of macroeconomics have become the firm’s views, but I don’t directly control our investment actions. What I will try to accomplish here is to try to apply the logic of my prior article to the residential real estate market. As opposed to my earlier article, I will try to show why I think we are close to a market top in residential real estate. There is reason for pessimism.
The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
This is what I see in many residential real estate markets now: panicked buyers are saying “this is my last chance,” and buying houses using risky forms of financing. At the same time, I read stories of despair as some potential buyers give up and say that a house is out of their reach for now; they waited too long. Occasionally, I see a few articles or e-mails regarding people who seem to be bright selling their homes and renting, but this is a minority behavior.
In the face of this, residential real estate prices continue to rise, particularly in the hot coastal markets, which tells me that the price momentum can continue a little while longer until it fails because there is no incremental liquidity available to expand the bubbles.
You’ll know a market top is probably coming when:
The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.
Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
Houses aren’t like stocks for several reasons:
- Unlike stocks, houses are used by their owners every day.
- We can short stocks, but we can’t short houses. (Personally, I hope no one comes up with a clever way to do so. We have enough volatility already.) The most someone can do is sell his home and rent.
- Perhaps the equivalent of a long-only manager is someone who owns his property debt-free, like me, and doesn’t see the need to lever up by moving up to a larger home. Measured against the standard of “what might have been” is a terrifying taskmaster from an investment standpoint. I avoid it in equity investing, and in home ownership.
- I am aware of a number of people (I have been assured that they are not mentally incompetent) who have sold their homes and started renting. This to me is the equivalent of going totally flat in equities, or other risky assets. Not that one faces negative carry, because the ratio of rent to in the hot markets is pretty low. In many markets, you can earn more off the proceeds than you pay in rent (leaving tax consequences aside). This leaves aside the issue of appreciation/depreciation of housing values, but when one can rent more cheaply than buying, it is a negative for the housing market.
- My point about momentum strategies is definitely pertinent here. With the existence of contract-flipping, a high level of amateur investment (seemingly under the guise of “buy what you know”), and a high level of investor interest (10%+), there is a lot of momentum in real estate investment. People buy because prices are going up. Some buy because it is “the last train out,” and they have to jump rather than be stranded. Nonetheless, momentum tends to maintain in the short run, and the slowdown posited last fall definitely has not occurred.
- Value vs. Growth does not exactly apply here, but in the housing market, people are paying up for future prospects more than they used to, which is akin to growth investing.
- This is just an opinion, but those who are making money in residential real estate today are inexperienced and less rigorous than most good businessmen. They see the potential for profit, but not the possibility of loss.
- Unfortunately, it is difficult to partially own a home. Home ownership is largely a discrete phenomenon.
- Using a concept from value investing we can look at the earnings yield that residential real estate is throwing off. Compare the rents one could receive from a property versus the cost that it would take to finance the property on a floating rate basis. What I am seeing is that more and more hot coastal markets earn less from rents than they require in mortgage payments. Property price appreciation is no longer a nice thing; it is required to bail out inverted investors. Contrast this with those that invested in tech stocks on a levered basis in early 2000; they paid cash out to hold appreciating positions, before they paid cash to hold depreciating positions, before they blew the positions out in panic.
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital. Here are ways that corporate behaviors change near a market top:
- The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
- Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
- Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
- There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
- Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
- Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
- Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.
In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.
- Every time a new home is sold, a privately placed IPO is held, with one buyer.
- When rates are low, it is no surprise that the homebuilders try to take advantage of the situation, and provide supply to meet the demand. But if it is only rate-driven, rather than from growth in real incomes in the economy, the quality of the new buyers will be low, because now they can just barely finance the house they could not previously. If their income level falters, they will not have any safety margin allowing them to hold onto the house.
- Private investors in residential real estate have multiplied at present. This is akin to an increase in venture capital.
- Leverage for new buyers has never been higher. This occurs through second and third mortgages, as well as subprime mortgages. Interest only mortgages are commonplace among new mortgages. Beyond this, investors hide themselves so that they can get the cheap rates associated with owner-occupied housing.
- With housing, making the earnings estimate means being able to pay the mortgage payment each month. The degree of slack here is less than in the past.
These two factors are more macro than the investor base or corporate behavior but are just as important. Near a top, the following tends to happen:
- Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
- The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.
One final note about my indicators: I have found that different indicators work for market bottoms and tops, so don’t blindly apply these in reverse to try to gauge bottoms.
There is no options market for residential housing, but the Federal Reserve is still a major influence in the housing market. When the Fed is withdrawing liquidity from the system, the price of housing tends to slow down, if not reverse. Like the equity market, this is not immediate but follows a six- to 18-month lag. This is another case of “Don’t fight the Fed.”
No Top Now
There are reasons for concern in the present environment. Valuations are getting stretched in some parts of the market. Debt capital is cheap today. There are an increasing number of momentum investors in the market. Making the earnings estimate is once again of high importance. Nonetheless, a top in the market is not imminent, for these reasons:
- The Fed is on hold for now. Liquidity is ample, perhaps too much so.
- Actual price volatility is muted.
- Since all of the accounting scandals of the last few years, many corporations have cleaned up their accounting and become more conservative.
- Cash flow from operations comprises a high proportion of current earnings. More dividends are getting paid.
- Leverage has not declined, but most corporations have succeeded in refinancing themselves in a low interest rate environment.
- Conservative asset managers have not been fired yet.
- Most IPOs don’t seem outlandish.
Not all of the indicators that I put forth have to appear for there to be a market top. A preponderance of them appearing would make me concerned, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me out of the trouble in 1999 and 2000. I hope that I — and you — can achieve the same with them as we near the next top.
The current market environment is not as favorable as it was a year ago, but there are still some reasonably valued companies with seemingly clean accounting to buy at present. Right now, being long the market is more compelling to me than being flat, much less short.
I would retitle this the “The Top is Coming Soon.” The reasons that I mentioned to be worrisome remain:
- Valuations are getting stretched in some parts of the market.
- Debt capital is cheap today.
- There are an increasing number of momentum investors in the market.
- Making the earnings estimate is once again of high importance. (Gotta pay my mortgage!)
But there is more that makes me even more bearish:
- The Fed is on the warpath, and liquidity is scarce.
- Appraisals overstate the value of property that financial institutions lend against.
- Homeowners have a smaller margin of safety than they have had in the past.
- Leverage has increased for the average homebuyer.
- People are paying more than they ought to for new and existing homes.
I am decidedly a bear on housing prices (at least in the hot coastal markets) at present, but I recognize that momentum can carry prices far beyond sustainable levels. That’s the way markets work.
Nonetheless, I am still a bear on those who build homes, and those who finance them. We are at an unsustainable place in the ability to finance the residential hosing market. Either an increase in interest rates or a decrease in ability to pay for housing can derail the market. This is the inflection point that we are at over the next year.
By David Markel CFA of alephblog