by Ivan Martchev | November 2, 2012 7:00 am
Before doing the victory lap for the great monetary experiment of “quantitative easing,” Fed Chairman Ben Bernanke needs to show how he will successfully unwind the $2.8 trillion in assets on the central bank’s balance sheet. Since this never has been done before on such a massive scale, many economists and investors are watching with bated breath, and some must be beginning to feel like monetary lab rats.
I know I am.
But, we are far from the unwinding phase as on Sept. 13, the central bank announced “QE Infinity.” Since the Fed will continue reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities, the Fed’s holdings of longer-term securities will increase by about $85 billion per month through the end of the year. This is, in effect, resuming the bank’s balance sheet growth, which had stagnated for more than a year.
Five weeks after QE3 was announced, we found out that U.S. housing starts surged 15% in September to the highest level in four years — a 872,000 annual rate, which exceeded all forecasts. Naturally, two questions arise: Is the worst over, and is the Fed to thank for the housing turnaround?
While all the “QEs” have definitely helped push U.S. Treasury yields lower and helped narrow spreads to mortgage bonds, the situation in Europe also has helped the U.S. government bond market. Spanish 10-year government bonds currently yield 5.49% while Italian 10-year government bonds yield 4.76% — both multiples of similar maturity U.S. Treasury bonds or the relevant German bunds.
It seems to me that a lot of money from more problematic parts of Europe is hiding in Treasuries and bunds. Should this situation — ongoing for almost three years — ever be resolved, U.S. Treasury yields likely won’t remain at such depressed levels. And such a rise in bond yields likely won’t aid the current housing recovery.
The housing market is far from sizzling hot despite a deceptive decline of America’s monthly supply of homes to 4.5 months (down from a peak of 12 months) due to shadow bank-owned inventory and the like, but the improvement still feels like more than just a “thawing of the ice.”
Housing affordability actually is better than it was before the housing bubble started, which itself was the result of creative financing and improperly originated mortgages, not necessarily of low interest rates. It is fair to say that if only conventional mortgages were allowed, we wouldn’t have seen as big of a housing bubble and subsequent bust. The preference for conventional mortgages today also is a reason for our slow recovery speed.
I believe banks that survived the financial crisis in relatively decent shape are in a position to take away market share and emerge as consolidators in the present environment; this might be the right time to own the closest thing to a plain-vanilla bank. The top four mortgage lender — Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM), US Bancorp (NYSE:USB) and Bank of America (NYSE:BAC) — are expected to report $6.9 billion of mortgage-banking revenue in the third quarter, a 37% increase from a year earlier. This will help the mortgage lenders generate a combined $10.9 billion in profit.
Companies geared toward a housing recovery also have performed admirably this year — from home-improvement retailers to homebuilders to home appliance makers. The SPDR S&P Homebuilders ETF (NYSE:XHB) has a lot more than homebuilders in it, with Home Depot (NYSE:HD), Bed Bath and Beyond (NASDAQ:BBBY), Whirlpool (NYSE:WHR) and Masco (NYSE:MAS) among the top holdings. This ETF is a broader play than just buying homebuilders, which have had a big run in 2012.
All homebuilders look expensive on a forward price-to-earnings basis as they rally in anticipation of further market improvement. Toll Brothers (NYSE:TOL) trades at 32 times next year’s EPS, yet earnings are slated to rise 70.8% this fiscal year and 109.8% next, based on consensus estimates. Toll Brothers is far from its peak profitability in 2005, but perhaps this is what is intriguing here.
When cyclical earnings are depressed after a prolonged industry slump — as is the case for all homebuilding companies — I like to look at book value both on an absolute and a relative basis. Toll Brothers’ peak book value was $3.59 billion in 2007; then after numerous charges, it dropped to $2.5 billion in early 2010. Toll’s “bubble” price/book ratio was 3.4 in 2005, while this metric dramatically fell to a discount to book in 2009 as the company took numerous charges to downsize its business. Now, Toll is a smaller company that is coming off the worst industry slump ever.
The long way back toward normalization in housing seems to have started. I believe housing is about to turn from a drag on the economy into an incremental positive in 2013. There are many ways investors can capitalize on this trend — but since I don’t expect this normalization to be as fast as it was in former recoveries, the more diversified and conservative the way to play it, the better.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Bank of America, Home Depot, JP Morgan Chase, Toll Brothers, US Bancorp, and Wells Fargo for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.
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