Momentum in equities when reputational risks are high

This blog originally was supposed to mostly be about investing tactics, but I got sidetracked when I discovered the housing issue that has ended up taking over.

Here is a post on the topic I used to dwell on - tactical investing for high returns by being insensitive to reputational risk. A recent example of this issue is Hovnanian Enterprises, a major homebuilder that is still so down on its luck as a result of the housing bust that as recently as July, it was being threatened with delisting from the NYSE.

All along, they have mostly just needed the market in new housing to recover.  They need revenue to fully regrow back into the financial and organizational framework that had developed under the Hovnanian name in 2005.  They have so much organizational and financial leverage that small increases in revenue will translate into large increases in market capitalization.  This will further be enhanced by knock-on effects of recapturing the value of tax assets and written down developments, and paying or refinancing debt at more favorable terms.

After the July delisting notice, Hovnanian released results of two quarters which have provided strong evidence that revenues will be growing and these positive developments will be coming.  Normally, efficient markets would internalize these developments immediately, and a firm's share price would immediately jump to a level reflecting the new expectations.  Financial research has shown a momentum effect.  In other words, a trend in share prices doesn't happen 100% at once.  It mostly happens at once, but there does appear to be some predictable serial correlation.  A recent trend shift or a recent positive or negative shock to a share price will tend to continue in the short term, to a certain extent.

But, in unusual positions where reputational risk has become acute, this momentum effect can become very large.  I am sure there were some institutional holders who were forced by their own rules to unload shares when Hovnanian received the delisting notice.  At some point, the reputational danger of having owned a stock or of recommending a stock, can overwhelm the objective value of it.  In these cases, the market for that equity becomes very tepid.  It's sort of like very thirsty wildebeests coming upon an oasis.  They very understandably approach it carefully at first, not sure if it is safe.  But, almost inevitably, the whole herd will be lined up at the shore, sucking up water vigorously.  To someone who happens to have been at that oasis when the herd showed up and recognizes already that there are no crocodiles, this process can seem excruciatingly slow.

Here is the Hovnanian stock chart from the past 6 months.  The positive shocks are noticeable after each quarterly announcement, but even those shocks took place over several days.  Following the initial quarterly shock, there was further upward drift for some time.  The more recent positive shock also took several days to play out.  It will be interesting to see if a positive drift follows this shock also.  If revenues do climb from here, the share value is likely many times the current market value.  Getting from here to there will reflect a combination of objective results, expectations, and changing reputational risks.  It is the implicit position on reputational risks that can provide very high returns over time, but it comes with the occasional risk of losses, and those losses will necessarily be devastating and embarrassing.

Source

Housing: Part 339 - Self-Imposed Stagnation

Here is a graph comparing long term real GDP growth per capita and per worker.  Also, I show the 10 year trailing average annual real total return on the S&P500.

Real GDP per capita had been rising by about 2% for many years.  Real GDP per worker generally rises at about the same rate, but in the 1970s, it dipped down to less than 1%.  This is because the baby boomers were entering the workforce, so the labor force was increasing faster than population was, and we weren't getting as much productivity growth per worker as we had previously.  Some of this might just be a product of worker composition and young workers being less productive.  But, I think this shows why the 70s were a decade of economic insecurity even though it doesn't necessarily show up in real GDP growth or even real GDP growth per capita.

One plausible reason that equity risk premiums have been high recently and real bond yields low is that an aging population means that there are many households in the saving phase of their lives.  But, that doesn't explain the 1970s when real bond yields were also low.  In the 1970s, there was a surge of young adults.

Notice in this graph that total returns in equities seems to track pretty well with GDP growth per worker.  Since investor expectations can't be measured it has become widely accepted that even long term stock market movements are the product of fickle sentiment and that stock market returns are more volatile than changing economic growth rates because of that fickle sentiment.  Relationships like this suggest that sentiment isn't as fickle as it has been claimed to be.

There also seems to be a widely held belief that the US stock market is overvalued because of loose monetary policy.  To the extent that that sentiment affects public policy, and I think clearly it has, it is probably one reason why real growth has been so slow.  I'd like to stake out the principle that in order to propose the goal that the central bank should aim to lower real returns for existing shareholders, your model of how the world works should be at a level of confidence that is practically certain in a way that few economic models have ever been.

In my Upside Down CAPM model of thinking about capital markets, expected real total returns are fairly stable, at about 7% annually.  This is a combination of expected growth and current income.  When growth expectations decline, savers become risk averse.  So, two things happen to equity returns.  First, the equity risk premium (the difference between Treasury yields and equity returns) widens because safe-seeking investors are willing to accept lower returns while total expected returns on at-risk capital like equity remains relatively level.  Second, the growth portion of expected returns declines, which means that the income portion increases.

Recently and in the 70s and 80s, payout rates were high (dividends + buybacks) and in the 90s they were lower.  Generally, payouts are referred to as a bottom up phenomenon, as if firms can't find good investments, so they send the cash back to investors.  I think this is more appropriately viewed as a product of low growth, so that there may be some correlation between high payouts and low growth, but that it is more directly a product of low growth because equity investors require more cash flow in their total returns to make up for the lack of capital gains growth they expect.

The changes in real returns over time are related to the changes in GDP per worker, due to both the real shock of lower productivity and lower expectations that will naturally come along with that.  Those past equity investors, on the margin, expected returns of around 7% plus inflation, and where their realized returns differed from that, it was due to changing profits and changing expectations from those unforeseen changes in real production.

This is all a long-winded way of getting to the point I want to make, which is about the current decline in growth.  Here is a similar graph, but here I am comparing GDP growth per worker and per capita to the percentage of GDP going to residential investment, because that is the main reason for the recent decline.


Before the financial crisis, there was little relationship between Residential investment and GDP growth.  Some of the short-term growth in the 2000s before the crisis might have been related to it.  But, as I tend to point out, that was at least as much a product of building in the 1990s being below long term norms than it was a product of excessive building in the 2000s.  The low ten year moving average in 1999 was unprecedented in post-WW II data.  The high ten year average in 2007 was not.  So, maybe a lot of the rise in per capita GDP growth from just under 2% to somewhat above 2% was from homebuilding.  But it was homebuilding production that was reasonable and sustainable.

But, what I want to talk about is the post-crisis decline.  That decline can clearly largely be attributed to collapsing residential homebuilding.  GDP growth per capita declined from about 2% to about 1%, and residential investment declined by 2% of GDP.

I like Arnold Kling's conception of patterns of sustainable specialization and trade.  It is better to think of an economy as a coordination problem with frictions rather than as a set of accounting identities.  And, I think it would be uncontroversial in any audience to suggest that this is a large part of what happened after the crisis.  There were millions of construction affiliated workers after the crisis that faced frictions in finding work in a different sector.  Possibly, the recent uptick in per-worker GDP growth, the recent low levels of unemployment, and anecdotal claims that construction workers are hard to come by, are signs that those adjustments have finally been made.

My disagreement with the consensus on this is that none of that had to happen.  For the past decade, those workers should have been engaged in building homes, and GDP growth per capita should have been 2% instead of 1%.  Not only would that have meant that none of those painful adjustments needed to happen.  But, it also would have meant that we would have about $2 trillion worth of housing providing the service of shelter for American households.  And, the result would have been that American households would be shoveling a few hundred billion dollars less each year of unearned rental income to real estate owners.  (Of course, this is complicated by the fact that many of those real estate owners are homeowners, who can only capture that "income" by staying in a home that has inflated rental value, but a suppressed market price, so they can't actually realize the gains from their economic rents except by living in a home that has rental value higher than it should have to begin with.  But, this is getting too far down the rabbit hole.)

But, here we are, a decade later, and maybe most of those former construction workers have either moved to other sectors or just dropped permanently out of the labor force.  So, then, what do we do about the housing shortage?

Well, I have written some about the inequities in the way we have contracted the housing market, and I expect to write some more.  But, really, in the end, there is nothing unsustainable about this context.  We could have achieved similar ends by raising property taxes, or any number of things.  All consumption has some foundation of technological, tax, and regulatory factors that has an effect on supply and demand.  Just because our current context seems inequitable to me, that doesn't mean it can't exist as it is.  Non-owners will consume less housing, owners will consume more, and real estate investors will earn higher returns than I think they would in my preferred regime.  But, it's a sustainable regime.

So, the "economy" doesn't need housing to recover.  It could be that we now are at a new pattern of sustainable specialization and trade, and the new pattern just includes less consumption of shelter by the have-nots.  The workers that have been on the sidelines for a decade instead of building homes have slowly found other productive things to do.  So, fixing the housing shortage is more about equity than it is about growth.  It is possible that we have finally entered a new phase of growth, that ten years from now, GDP per worker will have risen by 20% and equity investors will have earned 12% annually plus inflation, that working class families will be moving to Sacramento by the thousands so that young entrepreneurs can rent their old studio apartments in San Francisco for $7,000 a month, and that marginal workers will still be paying $1,000 rent to live in homes in Cleveland that they could buy for $60,000 because we have decided as a public policy objective that it is too dangerous for them to have a mortgage.

Every line in those graphs could move back toward the top while the residential investment line stays at the bottom.  We would just live in an economy where some households don't consume housing like we did in the past, and real estate capital earns slightly higher returns.

PS: Since equities aren't as tied to domestic production as they used to be, it could be that the rate of real total return on equities will be less volatile going forward as a function of changing domestic productivity.  So, it could be that equity returns for the S&P 500 over the past ten years are higher than they would have been 40 years ago, given the same slow rate of GDP growth per worker, and that it won't rise as high as it used to with rising US productivity.

International Comparisons of Equity Markets and Economic Growth

I don't really have anything interesting to say about these things, but I was comparing equity markets from some of the "housing bubble" countries, and I realized that while the US market has basically doubled from its pre-crisis high, Canada, Australia, and the UK all remain below it (in dollar terms, using US-based national ETFs).



idiosyncraticwhisk.com   2019

Maybe it's not that interesting.  Maybe, the US, Canada, and Australia are all basically moving in the same direction, and Canada and Australia had equity booms in 2007 because they are highly weighted in commodities.  And, maybe the UK has suffered from the double whammy of being the financial center for a stagnant continent.

But, at first glance, this throws me a bit for a loop.  My story is that first our economy was being held back by urban housing constraints, and now it is being held back by credit market constraints.  Both constraints, as far as I can tell, have been more severe than the constraints in the other countries.  Certainly the constrained mortgage market has been.  Yet, during the decade where our banks have been unable to fund housing and rising rents are reducing real economic growth, we are the outlier with fantastic equity growth.

Now, I can tell a just-so story here - that the housing problem costs households but it actually protects urban firms from competition to the extent that their host cities maintain a geographic monopoly on their core networks of skilled labor.  And much of those firms' profits are from overseas revenues.  The rising stock market is somewhat divorced from the broader economy, and housing is part of it.  But, I'm not sure I have a way to confirm that that isn't an ad hoc story.

Source

Here are graphs of GDP growth and unemployment rates.  Here, clearly Australia is the winner and the UK is the loser.  It's a pretty stark contrast between Australia's straight-as-a-post GDP growth and the collapse of its equity market during the crisis.  But, again, this is probably mostly due to the economics of commodities.

Source

On the unemployment rate, the US was the clear loser during the crisis, which I would attribute to the collapse of the construction sector after the mortgage industry was fettered and to less stabilizing monetary policy.  Although, real GDP didn't drop particularly sharply compared to the others.

But, unemployment has improved with the rising stock market, even though GDP (relative to the others) has not.  The same can be said for the UK.  Unemployment has been surprisingly positive there even though both GDP growth and the stock market have been poor.

Broadly speaking, I have spent most of the past few years double checking the conventional narratives about what has been happening economically, and I have become accustomed to finding data that decisively bends convention over and paddles it across the rear.  This is an unusual case where the data doesn't easily form a story that jumps out with a clear explanation.

Maybe part of what is going on here is that stock markets map to where the securities are traded, and that isn't very correlated any more to where the value is added.  Maybe stock markets just aren't good proxies any more for domestic production.  Not because of old shibboleths like "the stock market isn't the economy", but because the stock market is basically representative of parts of the economies of various locations around the world.  They are more representative of sectors than of geographical areas.

Yield Curve Watch

It looks like the market expectation is that this is the cyclical high point for the Fed Funds Rate.  It will be interesting to see if the FOMC insists on any more hikes.

In the meantime, the yield curve has become quite inverted.  Here is a chart of Eurodollar futures, which I like because it has a longer duration than Fed Funds futures.  The higher line is the yield curve on November 8, at the high point.  Even then, it was slightly inverted.  But, since then, even though near-term Fed Funds expectations have fallen, the yield curve in the 2-3 year range has fallen more.

Here, you can see how, at these low rates, there is a natural upward slope to the yield curve because the zero lower bound creates asymmetry in the expected yields on longer durations.  If you are using 10 year treasuries or some other longer term yield to estimate the yield curve, then you are getting a false signal.

I would say that, at this point, barring an unlikely additional bump in long term interest rates, the question is only how hard the landing will be, and that depends on how quickly the Fed reverses course.  It would be prudent if at the January meeting they pulled back 25 or 50 basis points, but that doesn't appear to even be in the set of potential options.  That would be the only chance at getting the "normalization" to 5%+ that I hear people talking about in long term interest rates.

It seems like the prudent position to take here is to maintain defensive positions until interest rates head back toward zero, and be ready to transition to equity at some point after the Fed starts to chase the natural rate down.  There could be a lot of noise between now and then, but it seems likely that in a year or so, equities will be available at prices near or below today's level and Treasury yields will be lower. (These are poorly informed opinions.  Do not use this blog for investment advice, etc. etc.)

Housing: Part 267 - Lot Size and Housing Demand

I haven't written much about this, because I'm not sure that the aggregate data bears this out.  But, the trend is so universal and extreme in the Phoenix area, there has to be something going on.

Since the financial crisis, new homes in Phoenix have been squeezed into very small lots.  There are many in-fill residential developments going up with two story homes that have barely more than a back patio.  This is especially surprising because the growth of Phoenix has largely been based on affordable middle class homeownership, and part of that ideal has always been the backyard swimming pool.  Most of the new homes since 2007 don't seem to have room for a pool.  This is a fundamental change.

The reason I think this is the case is because land prices are high because of low interest rates.  We can see this in the price of farm acreage, which has remained high.  But, home prices have been pushed to a level below their previous norms because of repression in mortgage credit markets.  This means that demand for housing in Phoenix is held down, putting downward pressure on the quantity of housing purchased.  And that demand is constrained by limited credit access, not by spending preferences.

The price of the home itself, in places like Phoenix, will be regulated largely by the cost of building.  So, the cost of lots is high and the cost of the homes themselves is relatively level.  If we didn't have repressed mortgage credit, this wouldn't matter much.  Low real long term interest rates would lower the cost of the mortgage at the same time they would raise the cost of the lot.  Home sizes might rise, but not so much at the expense of the lot.  Today, I think there is tremendous downward pressure on lot size - enough to lead to these fundamental shifts in home design.

Since financial repression is the binding constraint in housing markets, this upends many intuitions we might have about the market.  Yields on housing investment are very high while long term real interest rates on treasuries are very low.  This is odd.  Future market shifts will not be a result of these yields moving in parallel, which is what they might have done in the past.  Future market shifts will more likely result from these yields re-converging, in one way or another.

With continued financial repression, that might mean that housing starts remain low, rent inflation high, and generally real housing consumption will continue to decline until a new equilibrium is reached.  I'm not exactly sure what the endgame looks like there.  I suspect there would be a two-tiered market where upper middle class families would tend to live in larger homes while other families would rent smaller units.  Maybe in that case, these large patio homes would remain the norm in entry level markets, especially if low real long term interest rates remain low as a result of the various ways that capital repression maintains the limited populations and high costs of the Closed Access cities.

But, if financial repression is eased so that marginally qualified borrowers can buy homes again, then home prices should rise and long term real interest rates will also rise.  In that case, lot sizes will also increase in some cities.  Our intuitions will tell us that rising interest rates and rising home prices will cramp housing demand and favor entry level homebuilders of the kind that are building these crowded new neighborhoods.  But, in that scenario, it might be the case that neighborhoods which have been planned and permitted for very small lots would be out of favor, and builders with larger lots would gain market share.

This is all academic.  The sorts of shifts in mortgage market regulation I am describing here aren't even on the political radar right now.  So, it's probably not particularly useful to you as a reader.  But, I am reminded of this issue every time I drive around suburban Phoenix and notice those incredibly small lots.

Equity Returns and GDP Growth

Part of the secular stagnation story is about demographics.  Real GDP growth has been lower than at any previous time since at least WW II.  But, if we adjust this for labor force growth, we see that real GDP growth is low, but it is within the range of previous periods.

Even so, notice that real GDP growth per worker is currently very low, even though we are in a recovery phase, and it has been near zero twice since the recession.  In the post-WW II era, this has generally been associated with a recession.  Maybe this is related to the Great Moderation.  When real GDP growth per worker was low in the 1970s, quarterly growth whipsawed through recessions and recoveries.  Now, both the top and bottom have been moderated, so we get a slow, grinding recovery with the same level of real GDP growth per worker.

S&P Data from Robert Shiller

It looks to me like, over the long term, returns on equities are related more to real GDP growth per worker than they are to unadjusted real GDP growth.  They certainly are more related to real GDP growth, over the long term, than to nominal GDP growth, even though the zeitgeist currently seems to accept some sort of Austrian business cycle idea that monetary accommodation leads to real stock market gains.  I think this is an error.  The stock market rises when the Fed accommodates because monetary policy has been too tight throughout the current period, so accommodation leads to real growth, and a rising stock market is a secondary effect of real economic growth.

As we see in the second chart, the returns to equities are much more variable than changes in GDP (a 200% ten year return corresponds to average annual GDP growth of around 2%).  This makes it look like there is a reaction of equities to nominal growth, because if nominal accommodation leads to real growth, equity returns will have gains in excess of the real GDP gains.

But, the point here is that, even adjusting for the demographic problem, there is a stagnation problem.  It's not particularly worse than the problem we had in the 1970s, but it is a problem.  GDP growth, adjusted for labor force size, needs to recover if we are going to see better returns to equities over the next decade.  (Total returns to equities have been much worse than they look in the past couple of decades because returning capital through buybacks instead of through dividends creates a side effect of inflating the stock indexes, but it doesn't really change total returns.  So, whenever someone uses an unadjusted stock index, like the S&P 500, without adding in dividends, it will be skewed.  I am probably making a separate error here, because I am comparing S&P returns to GDP, even though corporate revenues have become increasingly global.  That's something to keep in mind.  Maybe adjusting for foreign profit would add a downward trend to the equity returns, and make them look more like the unadjusted GDP growth.)

I'm still not sure if the secular stagnation problem is a demographic problem.  There seems to be a general sin wave pattern of 35 years or so that goes back at least to the early 20th century.  Maybe, this is a shadow of the demographics issue.  Maybe, when baby boomers were crowding into the labor force in the 1970s, they were bringing down productivity because there was an inflow of young, inexperienced workers.  And, today, they are bringing down productivity because low labor force growth today is the result of retiring baby boomers who are leaving the labor force at their peak levels of productivity, taking a lifetime of experience with them.  Maybe, we have another decade or so of this, and when the baby boomer retreat has peaked, growth per worker will naturally begin to rise again.  Buying in after the next recession might be like buying in after WW II or after the 1982 recession.  It's probably more like the post-WW II period, because inflation and nominal bond yields are low, so that there will probably be a period of significant excess returns to equity, like there were in the 1945-1970 time period.

We are the 100% follow up.

Earlier, I was lazy, and I compared compensation and capital income over time with a measure of capital income that included corporate tax.  But, over the long term it is after tax capital income that will equilibrate in domestic incomes.  So, I subtracted corporate tax from the "operating surplus" measure.  This makes the relationship stronger.  Over time, real compensation and real capital income before tax have a .9724 correlation.  Compensation and real capital income after tax have a .9756 correlation.  This is especially interesting, since corporate taxes are pro-cyclical, and so on a cyclical level, corporate income is more noisy after taxes.  (Effective corporate tax rates go up during contractions because losses aren't fully and immediately deductible.)  Even with that extra cyclical noise, removing tax from capital profit strengthens the relationship.

Taxing capital income is not an effective way to break us apart.  We are the 100%.

PS: As commenter Blissex pointed out on the earlier post, this should probably also be adjusted for population.  Adjusting both income levels with the size of the labor force reduces the correlation to about 92%.

We are the 100%.

Eons ago, I told commenter TravisV that I intended to look at this paper, and I finally have.  The abstract is:

Three mutually uncorrelated economic disturbances that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952. A model is employed to interpret these disturbances in terms of three latent primitive shocks. In the short run, shocks that affect the willingness to bear risk independently of macroeconomic fundamentals explain most of the variation in the market. In the long run, the market is profoundly affected by shocks that reallocate the rewards of a given level of production between workers and shareholders. Productivity shocks play a small role in historical stock market fluctuations at all horizons.

This would appear on the surface to push against the notion that we are the 100%.  Over the long term, fluctuations in stock market value come from reallocation between workers and shareholders.

The actual findings of this paper are interesting and useful, but I think we need to be careful about how they are interpreted.  Much like the Mian & Sufi findings about the housing boom, mostly what is going on here is that they have adjusted away almost the entire story, and they are analyzing the small sliver that is left.  They have detrended the data exponentially.  For instance, take a look at this graph from the voxeu article:

Over the long term, we can see here that fluctuations from the trend largely correlate with changes in the share of income to shareholders.

From the article's conclusion:

Technological progress that raises aggregate consumption and benefits both workers and shareholders plays a small role in historical stock market fluctuations at all horizons...
Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. The shocks responsible for big historical movements in stock market wealth are not those that raise or lower aggregate rewards, but are instead ones that redistribute a given level of rewards between workers and shareholders.

This seems like misleading interpretation to me.  We are talking about a 10% fluctuation over a period where the trend growth was something like 700% in real terms.

Here is a scatterplot of real capital income and real compensation since WW II.  If you want to know what capital income will be in a given year, an extremely good proxy would be knowing the level of compensation in that year - and vice versa.  The correlation is .97.

So, whatever we might learn from this paper - and there are things to learn from it - it seems very important to keep in mind that this paper is about a 3% portion of the total story.

It seems to me that the quote above should be prefaced with the sentence: Technological progress that raises aggregate consumption and benefits both workers and shareholders explains general growth in stock market values, which is about 97% of the growth in income and wealth.  Shifting factor shares might explain much of the other 3%.

It's a shame that the human psyche is so drawn to battles over relative status.  The story of human history and human advancement is a story of the battle to overcome this mental defect.  We are the 100%.  How much social attention is paid to the 97% of the story versus the 3%?

The largest risk of economic dislocations, like what we have seen over the past couple of decades, isn't the actual shocks themselves.  It is the human tendency to retreat into battles over relative status.  Notice that their measure of the effect of factor shares on stock wealth has declined since the late 1990s.  How's that workin' for ya?  Is there any disagreement that 1968 and 1998 were better for both shareholders and workers than 1978 or 2008?

Follow-up

Should I be bullish on manufactured homes?

I'm mostly on the sidelines regarding the housing/treasury position until the smoke clears a little more on mortgage expansion.  In the meantime, I noticed that manufactured homes just had their best quarter is quite some time, with unit sales up about 20% over last year.  Could this be the outlet valve for some of the pent up demand for housing?

SAAR, monthly

Manufactured home sales are well below previous norms.  It seems to me that sales could easily double from here, or more.  And, if financing might be able to expand since much of it is outside the traditional bank-held or conventionally securitized mortgage market, maybe manufactured homes get a boost for households without other options.

I might have to look into this.

Comments welcome.

Real economic growth is what moves equity prices.

Tom Clougherty, at Alt-M, builds on George Selgin's great post on the Fed's peculiar behavior in 2007 and 2008, where they sterilized their emergency lending activities by selling treasuries, which had the effect of creating tight monetary conditions.  He references this interesting piece at Cato, from Daniel Thornton, who was an advisor at the Federal Reserve Bank of St. Louis before he retired in 2014.

But, as much as I applaud how each of those pieces pushes back against both the idea that the Fed was accommodative in 2007 and 2008 and the idea that QE operated through the reduction of long term interest rates, I still see a tendency to fall back into some of the same assumptions.  From Thornton's piece:

If the Fed distorted asset prices between June and December 2003, one can only imagine what the FOMC’s zero-interest-rate policy over the period December 2008 to the present has done. And, of course, Kohn is correct: the intention of the policy is to distort asset prices in an attempt to reduce long-term yields. But such actions produce unintended distortions: a strong and persistent rise in equity prices, a marked change in the behavior of commodity prices, a resurgence in house prices and residential construction beyond what is warranted by economic fundamentals, and excessive risk taking, even by those who are least well situated to take it. These are the unintended consequences of QE and the FOMC’s zero-interest-rate policy.

I have written extensively in my ongoing series about how home prices were not high in 2003 because credit or artificially low short term rates had pushed them above levels justified by fundamental valuations.  I am pleased to see momentum in opinions about monetary policy that points out the hawkish policy decisions they were making before and during the financial crisis.  But, the idea that home prices were unjustified is so powerful and so palpable, that even in the midst of these questions, questioners tend to accept whatever assumptions are required to conclude that the housing and equity markets were overvalued because of monetary policy.  Thornton, for instance, in his article, sharply questions the idea that low long interest rates reflect expectations of loose policy that creates persistently low short term rates.  I agree with him that that model seems incoherent.  But, when it comes to explaining rising equity or housing markets, he seems surprisingly willing to accept that model.

I understand that this is difficult.  The idea of a housing bubble seems unassailable.  To attempt to argue against it would be reputationally risky - certainly too risky to entertain the idea in a sort of back-of-the-envelope initial line of questioning.  I believe that the reason I might get to be a voice in popularizing the idea that there wasn't a bubble may be because I have done such a smashing job of avoiding having any reputation to ruin.

So, in a way, the intellectual barriers to my narrative are strong.  Yet, on the other hand, Clougherty, Selgin, and Thornton have already accepted the fundamentals of my narrative in other contexts, so they don't need to be convinced to change their fundamental beliefs; they just need to be convinced to apply them more thoroughly.

I have plenty of posts in the housing series that go into the details of housing valuations.  In this post, I want to mention equities, because the same sort of assumptions seem to be feeding ideas about equities.  Most observers seem to attribute rising equity prices to monetary accommodation, credit expansion, and "reaching for yield".

Most analysis of equity pricing behavior uses price movements or total returns over a period of time.  I think this conflates income, capital gains, expected returns, and real shocks, and leads to a lot of confused analysis.  I believe that if we look only at expected (or "required") returns on equities, we find a surprisingly stable real implied yield on corporate equity over long periods of time.  Aswath Damodaran at NYU has developed an extensive data set of variables that allow us to analyze equity values back to 1960.

The Capital Asset Pricing Model gives us the following very simple equation for valuing equities:

In English, the required expected return on an equity is equal to the risk free return plus an equity risk premium.  For individual stocks, this premium would scale with "beta", which is the sensitivity of that stock to volatility of the broader market.  The market, by definition, has a beta of 1, and I generally prefer using 10 year treasury rates as the risk-free rate that is most relevant to equity values.  So, for the market as a whole, expected returns are simply the sum of the risk-free rate and the equity risk premium.

For returns on bonds, all we need to know is the coupon, because cash flows are fixed and expected inflation is paid as a portion of the interest rate. (A 5% bond might be earning, say, a 2% real yield plus a 3% inflation expectation.) But, equities (and homes) are real assets, so cash flows rise over time with inflation or real growth.  This means that to estimate the equity risk premium, we need to estimate the expected growth in cash flows.  For equities over the long term, this is the expected growth of net profits.

One problem we have with this question is that we have only had market rates on real bonds for about 20 years, so before the late 1990s, it is very difficult to separate inflation expectations from real growth expectations.  But, to the extent that we have data, I interpret Damodaran's work to be turning the CAPM on its head.  Real expected returns seem to be very stable.  Most of the changes in equity prices come from real shocks to corporate earnings and changes in growth expectations.

This means that "reaching for yield" does not describe market behavior.  And it means that if accommodative monetary policy is pushing market prices up, this is probably a sign that policy had been too tight, and accommodation is improving the broad prospects of the real economy.

Here is a graph comparing the required returns to equity (ERP + risk free rate) to treasury bond rates since 1961.  There are basically two eras here.  Before the mid-1990s, real rates fluctuated somewhat, but they were swamped by fluctuations in inflation.  This makes it appear as if ERP required returns on equities and risk free rates move together.  But this is confusion.  Equities (and homes) are real assets but treasury bonds are nominal assets.  Required returns to both are sensitive to inflation.  But, if expected real returns to equities are fairly constant over time, this means that when risk free rates rise, ERP would tend to fall at a similar scale.  When fluctuations in inflation are large, the positive relationship regarding inflation covers up this inverse relationship regarding real returns.

Since the late 1990s, we do have markets for real risk free rates.  But, inflation had settled down enough by the late 1980s that we can get a pretty good estimate of real rates back to at least 1990, simply by subtracting inflation from nominal rates.  Here I have used the GDP deflator as the inflation proxy.  So, we have the era before 1990 where fluctuations in inflation dominated, and we have the era since 1990, where inflation has been fairly stable and real risk free rates have dominated.  This means that during this period, if required total returns to equity are, indeed, stable, we should see a negative relationship between ERP and risk free rates.

Here is a scatterplot of ERP and 10 year risk free rates (minus inflation) since 1989, together with the scatterplot of ERP with the market rate on real 30 year bonds since 1999.  Here we see this strong inverse relationship.

Since 2008, Damodaran has estimated ERP on a monthly scale.  Here is a graph of monthly total required returns on equities (risk free rate + ERP).  After the disastrous events of September 2008, there was a brief bump in required returns to about 10%, which subsided back to the stable 8% nominal level by the summer of 2009.  So, the brief deep plunge of equity values that bottomed out in March 2009 was part of a brief shock away from the typical required level of returns.  But, later in 2009, required returns simply moved back to their normal range, and none of the subsequent gains had anything to do with "reaching for yield".  They have mostly reflected real recovery of nominal spending and corporate earnings.

Here are scatterplots, using market rates on TIPS bonds, of monthly ERP since September 2009, compared to both 10 year and 30 year real interest rates.  Again, we see a strong inverse relationship.

This suggests that changes in long term real interest rates have little or no effect on equity prices.  The ramifications of this are stark.  This means that gains in equity markets should be taken as a sign of optimal monetary policy.  To the extent that policy makers are calling on monetary policy to tighten up in order to rein in "overheated" asset markets, they are literally calling for monetary policy to tighten up until it has damaged broad, real economic growth.  Loose money or low rates do not cause equity markets to "overheat".  Even if monetary policy is inflationary, this will not lead to persistent increases in equity values, because the stable required returns on equities are real returns, not nominal returns, so equity prices should be unaffected by inflation expectations in the medium to long term.  And, clearly, when monetary policy was overly inflationary in the 1970s, stock prices were tempered.

This also speaks against the idea that low interest rates are related to leveraged corporate risk-taking.  If corporate assets have a stable discount rate, then low real interest rates should be taken as a much stronger signal of risk aversion - not risk-taking.  And, I do believe that this error in interpretation is one of the elements that led to the misidentification of high home prices with speculative over-reach.

Home prices do behave differently than equities, though.  Cash flows and discount rates on homes are more similar to real long term bonds, so home values can move up when long term real interest rates are low.  In my next post, I will return to that topic, with more of my analysis of how even that effect would be mitigated in the absence of the supply constraints which were the primary cause of home price appreciation in the 2000s.

PS:  These are the scatterplots above, using 1 year or 1 month changes in ERP and real risk free rates unstead of levels.  ERP is a necessarily noisy estimate, so first differences have low correlations, but the coefficients are still surprisingly strong.

PPS. On second thought, these scatterplots of the first differences may be adding more heat than light, since inertia in equity prices, and earnings and growth estimates, would naturally lead to an inverse relationship in the short term.

Worrying Signals from the Bond Market

Along with today's decline in equity markets, treasury yields and inflation expectations also declined.  Five year forward inflation breakevens are now at 1.13%.

Here is an update of the graph I posted a few days ago, showing that short term TIPS yields have pushed even higher.  It's a little hard to pull out of the data, because TIPS markets have only recently developed, but this pattern of large premiums in short term TIPS yields also emerged in the summer of 2007 when the Fed signaled ambivalence about early difficulties in the mortgage market and emerged again before the fateful September 2008 Fed meeting.  I don't see a sign of this pattern at other times.  For instance, forward inflation expectations dipped down after the first two rounds of QE ended, but short term TIPS didn't signal deflationary shocks at those times.

Looking at the forward Eurodollar markets, I also see worrying signals.  The recent fall in interest rates has not been associated with a shift forward in time of the first rate hike.  That is still expected to happen between in October or December, as it has all summer.  The expected date of the first rate hike had been moving ahead in time, remaining about 6 months in the future.  During this time, I read the bond markets as gaining confidence.  The yield curve at the very short end slightly flattened, but the terminal rate moved up nicely, signaling higher expectations for both inflation and real rates to move toward the Fed's stated goals.  But, in June, bond markets appear to have accepted a resolve from the Fed to raise rates this year.  The expected date of the first rate hike stopped moving forward, and when it did, the slope and terminal height of the yield curve began to decline, along with inflation expectations.

And now, in the past few weeks, we have TIPS markets signaling a deflationary scare.  All of this, together, says to me that the bond markets do not have faith that the Fed will respond to current weakness in a timely manner.

Source

Source

If the bond markets are right, the question is, "Is this August 2007 or September 2008?".  On the one hand, there is some positive momentum in labor markets and industrial markets (outside of oil exploration).  There is no momentum in construction or real estate credit to destroy.  I take this as a sort of positive.  There is not a lot of activity to undermine there.  The economy's momentum is not dependent on real estate.  And, even though the zero lower bound distorts the yield curve, the long end of the curve is around 3%, and I doubt that it could distort it that much.  Normally, I wouldn't worry about more than a minor equity correction if the yield curve is not inverted.  Also, corporate leverage is low, profits are strong, and valuations are reasonable.  Equities shouldn't collapse unless there is a collapse in nominal incomes that creates a deep decline in corporate profits, like it did in late 2008.  Those factors suggest that the initial reaction to a hawkish error wouldn't necessarily be disastrous.  Equities didn't peak, surprisingly, until October 2007, and slowly declined by about 3% a month after that.    Profits had been falling slowly since 2006.  The collapse in equities in late 2008 was more or less proportional to the collapse in earnings that came after the September-November 2008 tightening.  On the other hand, 5 year forward inflation expectations are about where they were in September 2008.

It is certainly time to start thinking about forms of defense.  I'm not sure there is a safe and inexpensive hedge available.  Directional positions are dangerous, because they are basically a bet on the arbitrary decision of a committee of political appointees.  It's unfortunate that we impose this sort of uncertainty on ourselves.  Regardless of the policy decisions that happen as we move forward, how many productive activities are on hold now because of the uncertainty?  Even if we didn't have a market-based currency regime, wouldn't it be nice if the committee could quickly do something like simply announce that they would buy $100 billion/month of new treasuries until 5 year inflation expectations increase to 2%?  It seems to me like a conservative position to take, but it would be made out to be a big deal.  And, everyone from Rand Paul to Bernie Sanders would be talking about how the Fed was just covering Wall Street's backside, as if the only problem we have is a drop of a few points in equity markets.  As if labor and capital aren't part of a symbiotic relationship where early signals of trouble for both are often visible in capital markets.

HTCH Bleg

I've been long on Hutchinson Technology for a while.  Coincident with their recent quarterly report, they released news about improvements in their new product for Optimal Image Stabilization in smartphone cameras.  So, while investors remain in limbo with the turnaround that seems always to be 6 months away, this seems like a potentially transformative development.

Are there any readers with a foot in the smartphone business?  What is the unit sales potential of this in the near term?

Hutchinson is definitely a poster child for one of my speculating rules of thumb - that putting yourself in a position where you might be roundly embarrassed by your public positions can be very profitable.  I may not have mentioned this before, but that is also a very effective, and demeaning, way to bankrupt yourself.  Therein lies the rub.

Anyway, come on readers....Do you know?  Or, do you know someone who might have an informed opinion?

The Housing Half of the Treasury/Housing Trade

I mentioned the other day that it looks like things are turning up for a position that is long housing and short bonds.  On the bond side, I expect long term rates to move up as housing begins to attract capital again, and short term rate expectations should move up as GDP growth accelerates.  Short Eurodollar contracts in the early 2018 time frame seem like the best spot to target those movements.  That time frame should capture most of those rate movements while avoiding unrelated Fed discretionary moves regarding the date of the first Fed Funds rate hike or the cyclical peak in the Fed Funds rate.  On the other hand, if long term rates on housing and treasuries converge, generally, then there are probably more gains to be captured farther out on the yield curve as the entire curve moves higher.  My main concern there would be that aggressive hawkish postures by the Fed could hold those rates down while leaving rates in the 2016-2018 time frame relatively unchanged or even higher.  If the Fed somehow moves into a dovish position, long term rates and mid-term rates would rise, due to positive market conditions and inflation expectations, and this would also seem to favor that 2018 time frame.

Here's yesterday's graph of new home sales and home prices over time.  We can see here how home sales have suddenly moved up sharply, but still have a long way to go (although housing starts have not seen this same sharp move up in the last couple of months).  I have already noted that mortgages have begun to expand at the banks.  I expect home price growth to begin to turn upward again, also.  Note in this graph how home prices tend to lag home sales.  This supports my general thesis that home prices are sticky, and that much of the speculative activity in the 2000s boom revolved around that.  I had originally expected to be able to value homebuilders, in part, as land speculators.  But, their business and their valuations seem to be much more closely tied to sales volume than price.  I think this is partly because of this price stickiness issue.  The outlet valve for housing when the equilibrium price is moving sharply is the new home builders.  The quantity response moves through the homebuilders.

On the housing side, one way to take a position would be to take long exposure in a homebuilder that would be expected to gain the most from positive surprises in new home sales.  Here are two earlier posts on the idea.  Here, we really want to aim for a highly leveraged, high beta firm.  In addition, homebuilders tend to be sitting on large amounts of tax assets, many of which are still off the balance sheets at the firms that have struggled the most through the housing bust.  I had hoped to find a clever valuation method for these firms, specific to the situation.  But, generally, it looks to me like the homebuilders tend to have a pretty stable ratio for Enterprise Value / Revenues of 1 or slightly higher.  It tends to move up somewhat when growth expectations or margins are running high, but it appears to be a stable valuation metric for the industry as well as for individual firms.

It is running high now, partly because of those tax assets, although the tax assets don't generally amount to a large sum for the largest firms at this point.  Mostly, this valuation is running high because of growth expectations.  Analyst 2 year revenue growth for the industry is averaging about 33%, but I suspect that the market price reflects growth at more like 50%.  This isn't as crazy as it sounds.  Looking back over the past 20 years or so, 2 year growth levels during recovery times have commonly run in the 50-60% range.

In the next graph, homebuilder enterprise values are compared to current revenues and prospective revenues.  My "bullish" 2016 revenue level here equates to 2 year growth of about 66%.  That is similar to growth rates since 2012, and would put home sales in 2016 only back up to about the levels of the mid-1990s, so I don't think that is excessive in the current climate.  And, that puts industry-wide valuations, with some modest annual gains, at the range of baseline valuation levels when growth might be expected to moderate in a few years.

Because growth rates seem to be somewhat priced in, I am not sure how much gain is available, industry-wide, for a bullish forecast.  There might be 25% or more in industry-wide excess gains if my bullish forecast comes to fruition over the next 2 years, but I think the gains for the entire industry may be dependent on the length of time the recovery is allowed to run, and there is too much political/monetary uncertainty there for valuations to reflect hopeful growth more than a few years in advance.  So, what industry-wide gains there may be may happen in real time as the recovery progresses.

For this first phase, I think the gains will come mostly from the more distressed firms.  In these charts, the firms are arranged by leverage (red bars).  Debt here is shorthand for Enterprise Value minus Market Capitalization.  The blue bars reflect growth forecasts.  Dark blue is revenue, and light blue is how that growth would flow to equity holders, given current leverage levels.  Growth expectations are fairly tight across the industry, so the inferred equity growth is strongly related to leverage.

In the next chart, the measures are the expected market cap with an Ent.Value/Revenue ratio of 1 at 2014 revenue levels, 2016 forecasted levels, and my bullish 2016 levels.  All values are as a percentage of the current market capitalization.  All enterprise values have tax assets deducted (including off balance sheet allowances).  We can see that the EV/Rev. value is somewhat lower than most of the market capitalizations of the more healthy builders, and for the industry as a whole.  The builders who are highly leveraged are currently priced below that level.  (For instance, Hovnanian (HOV) would need to nearly double in price for its Enterprise Value to equal its current revenues.)  This makes sense, as the distress caused by the over-leveraged balance sheets creates added risk, so if a recovery does not come, these firms will likely suffer valuation losses.  But, these are the firms which offer the most upside from a bullish market.  And Hovnanian really is the firm most aligned to this proposal.

Betas for the firms also tend to follow the same pattern as the leverage levels, with Beazer, Hovnanian, and KB tending to have higher betas than the other equities.  I think this is a case where extremes in potential outcomes and betas can make it difficult for theoretical models to apply to actual financial performance.  Even Hovnanian tends to have a beta less than 2.  I think part of what happens is that things like operating and financial leverage do create a multiplier effect as revenue ebbs and flows.  But, additionally, the leverage also serves as a sort of optimization of a certain set of expectations about revenue growth.  So, some of what is actually beta will be measured as alpha, depending on how optimized that firm's leverage is to actual revenue growth.

Here is a graph of equity returns, normalized to current share prices.  Notice that since the crisis, Hovnanian has exhibited a beta that looks like something around 3 (compared to the industry), which is more in the range of the estimate for expected returns above.  KB and Beazer have also occasionally shown similar behavior.  But, what we see are separate periods.  Its measured beta (compared to the industry) has ranged around the mid 1's during this time, depending on the specifications you use.  But, depending on how conditions differed from expectations, the beta embedded in its current business model came through as very high levels of alpha (positive or negative).  Then, over the past two years, as housing has progressed more or less as expected with few positive growth surprises, along with a pause in home price appreciation, Hovnanian, has acted kind of like a call option, with a time decay, because by necessity their business model is optimized now for higher growth rates, until they move back toward their organizational capacity and optimal capital structure.  It also probably reflects less faith that tax assets will be claimed.

Statistically measured betas simply can't capture these nuances.  Good timing in these matters can capture gains that market-wide statistical analysis won't find.  Good timing ... that should be easy.  I mean, what could be so hard about that?

HTCH FY2014

HTCH posts fiscal year 2014 results this afternoon.  They recently issued guidance and refinancing news, which included bond conversions at $3 to $3.75, with the stock currently trading at $3.62.  So, while we are unlikely to be shocked by unexpected news, I am submitting this post before the report to maximize the likelihood of being roundly embarrassed by subsequent information.

Generally, recent results have been improving, though not as quickly as I might have hoped.  Last quarter they announced a potentially significant new product that utilizes their technology for optical lens stabilization in smartphone cameras.  I will leave analysis of that aside.  It serves as a sort of free option on forward valuations, and could amount to a large new revenue base.

While it is disappointing to swallow the up to 50% dilution coming from their refinancing arrangements, I think the problem is that they have the core business, which is recovering, but is scraping the limits of available working capital until positive cash flows can pull it higher.  And, they have this new, but unproven, revenue base, which is basically like a tech. startup venture.  Because of the point where they are in their core business' recovery, they can't leverage it for financing the new venture.  And, the new venture can't attract mature pricing on its own.  So, they have had to finance with bonds that have elements of early phase financing, including convertibility at relatively generous share prices.

Here is a post I did on HTCH about 5 quarters ago.  Operating results have been somewhat disappointing since then, mostly in terms of revenue.  Here is the forecast of a model based on gross margins.  At the time, this forecast was based on quarterly production of 130 million units with gross margins approaching 19% at the end of 2014.

In the September quarter, they produced 117 million units with 12-13% gross margins.  They have guided a slight increase in production for the December quarter.  In the June 2013 quarter that preceded the post with the graph, they had produced 99 million units with quarterly gross margins around 2% and TTM gross margins around 6%.

So, there has been significant improvement.  Disappointment has come mostly from revenue levels. Margins should still approach expectations at any given level of revenue, and management continues to stand by their guidance for higher market share on new dual stage suspension programs, even though the programs have taken longer to ramp than expected.

The model shown in the graph would predict a current share price of about $8.  It may be the case that the model overstates the current valuation because it is largely based on gross margins.  In the past, gross margins probably mostly captured changing revenues, but recent margin gains have come from cost cutting.  At gross margins I expect to see over the next 2-3 years, this model would predict a share price of $10-$20.  Maybe the contraction in the asset base that has coincided with the recent gross margin improvements would argue that this target range should be reduced.

On the other hand, market valuations for HTCH before the post 2007 decline in market share ranged in the 1x to 2x range for both Price-to-Sales and Price-to-Book.  These valuation ranges would also predict a share price in the $10-$20 range in the coming few years.  And, with the recent refinancing, even the stagnant market share projections with no projected OIS revenue point to annual Free Cash Flow of around 40 cents per share.  Projections more in line with guidance (my scenario 3) point to Free Cash Flow growing to more than $1 per share, even without OIS.  Keep in mind that there is a tremendous asset base here, much of which had been written off, and that depreciation levels are much higher than sustainable capital expenditures.  Plus, there are off-balance-sheet tax assets worth more than $5 per share, even with the recent dilution.

Here are projections of revenues and gross margins.  They have around a 22% market share currently.  This is down from around 60% before 2007.  The bottom scenario here projects a stable 22% market share, which would be well below guidance and would also represent a decline from recent trends.  The top scenario forecasts a 1% market share gain per quarter for the next 3 years, topping out at 34%.  This would correspond to growth of about 5 million additional units per quarter.

The final three graphs demonstrate the effect of the refinancing on the three scenarios going forward.  There were two main parts to the move:

1) A conversion of $15 million in debt exchanged for 5 million shares.
2) A planned exchange of approx. $37.5 of bonds with new bonds that include a conversion option at $3.75 per share.

Pre-conversion outcomes reflect forecasts before the refinancing.  The middle bars reflect just the first step.  The right, purple bars, reflect the balance sheet in the case where the second set of bonds are also converted to shares.

I have been slightly unfair in the graphs here, as the retired bonds were also convertible at a higher strike price, and I have not accounted for that previous potential dilution, as it would have only affected the best future outcomes.

These moves were probably necessary in order to secure working capital in the very near term in all potential scenarios regarding both suspensions and OIS.

In some ways, the dilution may not have been as bad as it seems because, by converting debt expense into profit, the refinancing brings Hutchinson into a more profitable position.  This has the effect of creating a little more of a safety net for the worst case scenarios.  But, it also has the effect of recapturing the tax assets more quickly.  We can see that at play in these last two graphs, where book value increases substantially from scenario 1 to scenario 3, but book value that includes the tax assets grows more slowly.  Since tax assets are currently larger than the enterprise value of the firm and represent an asset that provides no compounding returns to the firm during the time they are not utilized, the conversion provides a bit of a free lunch that partly mitigates against the dilutive effects on current shareholders.

While the delays on the hoped for returns on this position are aggravating, I continue to believe that the worst outcomes are diminishing in probability while the most likely outcomes provide valuations several times the current market value.

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.