Subprime Crisis Act II: The Greek Tragedy

Goldman's testimony was just a distraction. The real act was the country that gives us those letters to describe derivatives and volatilities.

Following last Thursday's report that Europe’s statistical office (Eurostat) had revised up the Greek 2009 budget deficit and Moody’s subsequent downgrade of Greece’s credit rating by one notch, another major rating agency S&P lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt.

That means Greece's credit standing is now "junk," or the sovereign equivalent of a subprime borrower.

The downgrad marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two notches to A- from A+.

According to Bloomberg news, Greek 2-year note yields soared 505 basis points to almost 19% and Portugal’s jumped to 5.7% as credit-default swaps on Europe debt surged to a record. The yield on Greek 10-year bond climbed 45 basis points to 10%. That makes the Greek bond yield curve even more inverted, signalling a short-term tragedy and a long-term pain.

The fear in the market is that the sovereign credit crisis may spread to other euro members, notably the other PIIGS countries.

What's the way out?

According to Stratfor,

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

Yet another way out perhaps is to let Greece out of the euro pact quickly, so that it can persue its own independent monetary policy (i.e. print money).

Whatever it is, the European banks or other investors holding these sovereign debts are facing the pressure of a massive writedown, thereby weakening the already weakened European banking sector. This threatens the nascent global recovery currently underway, but shouldn't derail it.

See a more detailed analysis on why PIIGS crisis matters.

Is Goldman a buy?

Goldman Sachs is facing a political firestorm. Some heads may have to go, but it has a deep bench.

The forward P/E and the trailing P/E all look attractive at 6-7 range, now that the price is at $152/shr.

Is it a buy? Popular bank analysis Dick Bove thinks so.

We note in the Abacus deal, John Paulson came out ahead with $1B, and the losers were a German bank, IKB, which lost $150M, and Royal Bank of Scotland (RBS), which lost $840M.

The congressional hearing on Tuesday may yet create more discount on the shares.

What drive the V-recovery?

More and more investors and business leaders now believe we are onto a normal V-shape recovery. The supporting evidence from GDP growth and leading economic indicators to corporate and consumer spending are just too strong to ignore. Yet this vision of a normal recovery clashes with other pieces of hard evidence of sluggish job creation, persistent high unemployment, sluggish construction spending and slow lending to consumers and small businesses.

So where does the apparent V-recovery come from? Is it for real and sustainable?

Many economists and analysts have tried to gain insights for these question by examining aggregate reports and statistics such as GDP, Employment Situation, Housing Starts, Existing and New Home Sales etc. While these analyses are useful, many important forces can get lost in the statistics and aggregation. Skeptics and conspiracy theorists will continue to find holes in any of these numbers and trends. Discussions can easily become sports fans' wars of taking sides, or economists' religious fights, both are largely a matter of which college they've gone to.

I'd like to do this differently. Much like what Warren Buffett has been doing by looking into Berkshire Hathaway's component businesses that are vital to the economy: Railroad, Banks, Home Construction and Mortgage, etc.

Today, let us examine one of Mr. Buffett's long-time holdings, American Express, in hope to gain more insights into the question imposed above. American Express (AXP) is nearly perfect for this purpose, as it is a global business focusing on credit-based transactions and credit lending. We all know that the great recession we are now recovering from was in large part caused by a credit crisis. Whether or not we're indeed experiencing a V-recovery must be reflected in its various business segments.

Last Thursday, AmEx reported first quarter net income of $885M, double the $437M it earned a year ago during the depth of the recession. Consolidated revenue increased 11% from $5.9B to $6.6B. Both exceeded analysts' expectations. Provisions for losses totaled $943M, down nearly 50% compared to $1.8 billion in the year-ago period. The decline reflected continued improvement in credit quality on the overall portfolio.

It is a very strong rebound. Almost V-shaped, as we will see below in more details.

AmEx has two broad segments: payment business (called "Billed Business" by the company) and lending business ("Cardmember Loans"). So it is very transaction- or spending-based, with about a quarter of sales coming from its leading business. Both businesses are international. They are very sensitive to the speed of economic activities and credit quality.

Chart 1 below from AmEx shows customer spending in dollar amount and in year-over-year (YoY) growth rates in both "as reported" and "FX adjusted" bases, month by month. Click to enlarge.

 
For the first quarter of 2010, customers increased spending by 16% from a year earlier. And the YoY growth rate has reached 20% for March. During the first quarter of 2009, the business had a most steep deline YoY in February when the growth rate was negative 20%. The recovery in growth rate is remarkably V-shaped.

In fact, according to the CFO, March 2010 has been the highest March ever for the billed business. During the conference call, when asked how can that be when more people are unemployed and companies seem to be spending less, the CFO said (my amphasis):

I think what we see here is when things improve that discretionary spending is coming back. I think it is really the impact of a more affluent customer base. I think that is one part of it. The next part has to do with corporate card. Corporate card generally is more of a V. It goes down sharper than the rest of spending and it comes back a lot steeper and I think we are seeing that make a strong contribution here. We have a very strong position in corporate card.

Thirdly we have a strong G&S ["Global Network Services"] business. As you can see from the charts spending on cards issued by our partners that run on our network is performing very well. ..

Right there are three important insights for the V-recovery. First, more affluent consumers have generally recovered, perhaps due to both of their more stable income and wealth recovery. We see more and more retailers catering to affluent customers reporting knock-out earnings and revenue growth. And, they are big spenders.

Second, corporations have come out of the recession in a much more healthy shape than consumers. It is really interesting to see the V-shape remark on corporate spending. Executives need to travel more as soon as business starts to pick up and corporate accounts are not as pinched as consumer accounts.

Third, both export and import have been surging. Trade with emerging markets has been a growth contributor, which has bounced back a lot faster than consumer-focused businesses.

We should also note that the current recovery has also been led by manufacturing and technology, most of the activities going there are tied to business-to-business and trade.

Chart 2 takes a further look at the growth rate of the billed business by its following segments: U.S. Card Services (USCS), International Card Services (ICS), Global Commercial Services (GCS) and Global Network Services (GNS). The first quarter revenue of these segments are, respectively, $3.5B, $1.1B, $1.0B and $997M. Click to enlarge.

The most V-shaped recovery is the GCS segment, "reflecting increased spending by corporate cardmembers and higher travel commissions and fees."

The GNS segment has been the most remarkable. It never stopped growing, although its growth rate was tempered by the great recession. The first quarter result reflects "higher merchant-related revenues from the rise in global card billed business, as well as an increase in revenues from Global Network Services’ bank partners."

Of course, not all of AmEx's business receovery is V-shaped. Its card member loan business has continued to decline. Chart 3 shows the growth rate comparison between this business and the billed business discussed above. Click to enlarge.

During the height of the housing boom, AmEx made a strategic mistake to expand its lending portfolio, thereby increasing its credit exposure to consumers who were already very stretched.

The credit crisis has put a huge dent in AmEx's financial performance. But over the course of 2009, the company has sought to shrink the credit exposure by lending less and by controlling credit risk. Recovery for loan growth, however, is nowhere in sight. This also reflects consumers' de-leveraging behavior coming out of the crisis. The declining loan growth is consistent with the "soft demand" claimed to experienced by U.S. commercial banks.

We are witnessing bifurcated recoveries: There is a strong V-recovery, at the same time there is also a very sluggish L-recovery, with the former more tied to corporate spending and international trade and finance, and the latter more tied to domestic and less-affluent consumers. Depending on where you look, you see a totally different recovery.

For the economy as whole, it will take the shape of where the leading/expanding sectors are point to: a "normal" V-recovery.

Watch Out for Standard Pacific’s Massive Dilution

This week’s releases on existing home sales and new home sales have ignited a sharp rally for home builders. The momentum seems un-stoppable, as more and more investors looking to participate in the government-assisted housing recovery.

According to Google Finance, year-to-date, the shares of Hovnanian (HOV) has gone up more than 80%, while Standard Pacific (SPF) has gone up more than 70%, and Lennar (LEN) more than 60%. The sharpest rally has been in the month of April, especially this week.

I have turned bearish on Hovnanian based on valuation concern. For Standard Pacific, I like its business model and its dominating exposure in California and in the South. But at $6-7/share, there is a massive potential share dilution hanging over its head.

When Standard was teetering on the edge of bankruptcy two years ago, a private equity firm MatlinPatterson from New York came in with a several hundred million dollars infusion. It saved the company. Moreover, the turn-around management team it installed has been successful in restructuring the company’s debt structure. At the same time, the team led by Ken Campbell was focused on controlling costs, selling off non-performing assets and other areas that are crucial for profitability. The company has also been early in acquiring lands in promising locations and communities. Impairment has stopped, and the company is now well-positioned.

All these did not come cheap. As of December 31, 2009, MatlinPatterson owns 450,829 shares of Series B Preferred Stock which are convertible into 147.8 million shares of common stock (as a point of reference, the current shares outstanding is 106 million). The conversion price is $3.05. As the stock heading higher, it’s only a matter of time before MatlinPatterson converts this massive amount of holding in preferred.

On top of that, the private equity firm also holds a warrant to purchase 272,670 shares of Senior Preferred Stock at a common stock equivalent exercise price of $4.1 per share, which is exercisable for Series B Preferred. And the shares of Series B Preferred will initially be convertible into 89.4 million shares of the common. The warrant may not be exercised in full before the stock reaches $10.5. But at this point, it is already quite far in the money.

A comparison in dollar value will help us understand just how much dilution the share holders will be subject to. For this purpose, let us fix the common stock price at $6.5/share. The current market cap is $689M.

If the preferred is converted into common right now, its value is $147.8*(6.5-3.05)M = $510M.


If the warrant is assumed to be fully exercisable and converted into common, its value is about $89.4*(6.5-4.1)M = $215M.

Add these all up, the if-converted total market cap would be $1.414B. Given the book equity of $435M, we’re looking at a potential market-to-book ratio of 3.25. That’s usually associated with high-growth stocks (Google’s is about 4.5, Cisco’s is about 3.8).

Just two months ago, when SPF was trading in $3-4 range, this was not a big concern yet. But now in the $6-7/share range, MatlinPatterson’s massive holding is becoming much more valuable than the current market cap. It’s only a matter of time before they flood the market to exit their astute investment.

For investors at large, it’s not a great idea to bid up the shares too much ahead of earnings. At this point, the company only has the potential to deliver, but has not consistently delivered the earnings that would justify the high multiple.

Other home builder stocks, especially the still-highly-levered Hovnanian (run by the same management that drove it to the ground), also appears to be running too much ahead of their earnings.


(I want to thank Seeking Alpha member Searsdog for bringing up this important issue. I’ve earlier put out a warning on my blog after Standard Pacific’s Q1 earnings release.)

Perma Bull?

Jim Paulsen's view on Normal recovery.
See my summary of his view earlier.

Wells Fargo, positioning well

WFC missed on revenue, but beat profit estimate. Unlike other large banks, Wells Fargo does not have an big investment banking or trading operation. So it didn't benefit from security underwriting or trading. The flip side of this is that its business would be the least affected among big banks if Washington pushes through its regulation to separate deposit-based banking from investment banking and trading.

It has two main sources of revenue: interest income and non-interest income. They are about equal in size, each brought in $11B last quarter. Mortgage income about flat, which means the company saw a soft loan demand. Deposit had continued to grow. Net interest margin came down a few basis points at 4.27%, largely due to this good problem: lots of deposit that earns no interest, but Wells could not find meaningful ways to park them. So they are keeping their gun powder dry. Wait for the loan demand to grow with the economy.

The biggest positioing story is of course the Wachovia integration, which appears to be on track. Company expects to achieve $5b in merger savings. The value in this merger is to convert Wachovia into an extension of Wells Fargo, using the same focused business model to realize higher efficiency and revenue generation by cross-selling more products to the same customer base. The end result will be a stronger coast-to-coast national franchise.

For a good summary, other than my take on its positioning, see this. Wells is getting everything ready to thrive in a growing economy when unemployment rate starts to decline materially.

Standard Pacific: Don't sweat the small stuff

Earnings was released early in the morning. Missed revenue projection by a mile. Surprisingly, the stock held up OK.

Despite the miss, there are things to like about the company's position: both  net new orders and backlog are up substantially year-over-year and Q-to-Q. Land acquisition is up significantly, and according the CEO, approved land deals in April was above $100M, which is about the amount approved in all of Q1 (itself a significant increase). These will translate into substantial land holding this year.

The company focuses on higher price points than entry level homes, so it's not competing directly with foreclosures. That is, it is focusing on move-up home buyers.

It is still focusing on controlling the cost structure and profitability, not so much on increasing sales and revenue. Company not looking to increase sales a whole lot year-over-year, due to high unemployment rate. Higher sale should arrive when the employment picture improves. That's when things get interesting.

During the call, CEO estimated that the company can comfortably do $2B in revenue when the housing market recovers. It did $1.1B in 09. With a disciplined margin control, if and when that happens we can expect annual net income to hit $100M. Roughly, the market cap can reach $1B. So from here to there, we're looking at a double.

CEO also mentioned that there are prospective buyers who do have jobs and qualified, but still need to feel more confident about keeping their jobs before making new home purchases. They need to see that the economy is adding jobs consistently to jump off the fence. That's my view as well.

This is the kind of micro-cap I like to play: it has a clear plan and is focused on a long term vision that it knows it'll come out ahead. At this point, Standard's stroy is all about positioning. When buyers return, which they will, the company will do very well.

Caution for investors: Watch out for the massive dilution that will for sure arrive when the private equity firm MatlinPatterson converts their Series B Preferred shares and their warrants. Until then, enjoy the bumpy ride.

Focusing on earnings

The first week of the earnings season turned to be rather eventful.

Intel and JP Morgan reported fantastic results that pushed the market higher. Google's somewhat disappointed.

March housing starts was a positive surprise, even though it's still way below average.

Friday was a bomb. SEC's charge against Goldman, combined with weak reading on consumer sentiment sent the market sharply down, erasing the gain for the week. Goldman story will linger on for months, as it's a poster child for Wall Street's greed and power. Everybody will be jumping up and down on this unfolding saga, and people are expecting more and more followup scandals and discoveries... the political risk of owning bank shares is getting even higher.

For bank stocks, two things to focus on. (1) We can avoid these Wall Street concepts. I've sold off JPM and BAC for that reason. I've stayed with my long-term holding WFC, for it has a very small I-banking business inherited from Wachovia Securities, and the rest is doing very well. I still think it could become the largest bank stock in market cap. (2) Pick up some of the bank stocks such as GS if they are excessively over-sold, so that the political risk is well-compensated. One of the Barron's articles argues that GS already looks under-valued after Friday's selloff. I agree somewhat, but the article may have underestimated the political fervor. Similarly, JP Morgan also looks expensive. Jaime Dimon's approach to dealing with Washington may not help. These Wall Street firms don't seem to get it: Washington will not leave them alone to do business as usual, doesn't matter what they say or do.

Last week, Sandra Ward had an article on Barron's about how retail investors are finally following the lead of institutional investors in getting into equity funds. It's well worth a read. I think there is more to come, which can turn out to be a powerful factor for the stock market.

James Paulsen's thesis on the recovery appears to be intact. This week, he re-confirmed the view by observing that "Despite persistent, widespread economic anxiety, the contemporary recovery appears remarkably normal."  That is, there is no "new normal."

According to Tax-Refund Monitor,

... taxes withheld in March  showed a very large increase over February. There were no changes in law or withholding schedules ... it often indicateds activity has accelerated, but is not yet being captured in the labor-market data. ...

Last Friday's WSJ, however, did have an article on "Tech Leads Jobs Recovery" that shows that Silicon Valley is ramping up hiring on tech talents.

Investors with a long term view informed by economic data will be in an advantageous position to play this market. Stay in the market, raise some cash when your winners become too large, and pick up good stocks when they're wacked by short-term forces. This is a sound strategy that I've played with with good results.

On Monday my favorite builder SPF will report Q1 earnings at market open. I'm somewhat optimistic. Citigroup, Goldman Sachs and Wells Fargo will report too. During the week there will be existing home sales and new home sales reports. It'll be very interesting.

Consumers to solidify the recovery

Consumers are out shopping in March, despite lower income and still grim job prospect. Confidence is getting back up.

Sales surged 1.6 percent, the Commerce Department said, up from February's revised 0.5 percent gain. Economists surveyed by Thomson Reuters had expected a gain of 1.2 percent.

The increases were across the board. Car dealers, home furnishing stores, building suppliers, sporting goods stores, clothing retailers and general merchandise stores all reported gains. Auto sales surged 6.7 percent, the department said, the most since last October.

I was wrong, the retail strength now looks quite solid.

JP Morgan reported great earnings today. Its nonperforming loans, those that are in default or close to being in default, totaled $2.7 billion, up $946 million from a year earlier but a $763 million improvement from the final three months of 2009.

"We continued to see delinquencies stabilize, and in some cases improve, in our credit portfolios," Dimon said. "Ultimately, the health of these portfolios will track the health of the economy."

The strong result is also telling me that I may have been too cautious about big banks.

Bernanke, testifying before Congress, said that consumers are spending again after having cut back sharply during the recession. Going forward, consumer spending should be helped by a gradual pick up in jobs, a slow recovery in household wealth from recent lows and some improvement in the ability to get loans.

High unemployment rate and low inflation, however will keep the Fed from raising the rate anytime soon.

Will Standard Pacific Pacify?

Investors have bid up Standard Pacific Homes (SPF) ahead of its Q1 earnings release next Monday (4/19). Since the company has a very large exposure in California, this is likely due to the March sales data just reported by MDA DataQuick. SoCal's sales volume has gone up 5% over the same period last year, and the median price has been up by 14%.

According to the same source, similar trend but smaller magnitude has been observed for January and February Southland home sales.

For Q1, analysts are expecting a $0.06/share loss, which is about -$6 M in net income, on revenue of $184 M.

The revenue estimate is very likely an underestimate.

In the March quarter of 2009, Standard recorded $209 M in revenue. Given the increases in both sales and prices year-over-year in one of the major markets where Standard operates, and the fact that the company has been ramping up in California, we think it's likely that the revenue will increase, rather than decrease substantially.

Newer communities, which may account for more than 10% of the company's total sales, should contribute higher margins. Compensation cost is expected to come down a bit. It is likely that the company will report a small profit excluding tax benefit this quarter.

While increased sales is certainly a big welcome, investors should look for increases in community counts and backlogs as the company heads for the Spring selling season. We will also be looking at the company's use of capital in new land acquisition, and the geographic distribution of its communities. How it positions itself to benefit from a rocky recovery is at least as important as how the last quarter turns out.

This is a very volatile stock. The share price can go up or down 20% easily around earnings release. Should the stock price continue to rise in the next few days, the stage may be set for a big selloff after earnings. If that doesn't happen, we may see a more pacific trading next week.
    

Is the U.S. Treasury Yield Curve Getting Even Steeper?

(This article has appeared on Seeking Alpha and has a lot of followup comments: http://seekingalpha.com/article/198205-why-the-u-s-treasury-yield-curve-should-get-even-steeper )

The yield spread between 10-year and 2-year Treasury notes has widened to record levels. In other words, the yield curve has never been so steep for a long long time. When it is steep, it is predicting future economic growth, usually. Could this time be different? Will it get even steeper?

There are many implications from the steep yield curve. Banks are obviously benefiting from it. Are are hedge funds who have access to low interest funding sources. Savers and retirees who depend on fixed income, however, are out of luck.

To fund deficit spending, the government may need to offer higher yields to investors. On the other hand, some investors seem to find it already attractive to own long bonds, helping the Treasury to raise billions of dollars.

The Fed 's easy money policy and massive federal spending however argues for the possibility of an even steeper yield curve.

The Fed is determined to keep the interest rate at the short end near zero for an extended peiod. Inflation is not yet a concern because capacity utilization is still very low and unemployment rate is still very high. In fact, it is conceivable that the Fed is determined to wait until it succeeds at creating inflation. Inflation will get the economy going, and it will help get the U.S. out from under its debt burden. Moreover, a weak dollar policy also helps to ease the trade deficit.

So for at least 2010, the short end will continue to be ancored down at zero. The long end will depend on two things: (a) investors' expectation of economic growth and (b) inflation.

People talk about these two factors as if they're independent. We think they're intertwined. Higher growth brings about higher level of economic activities, which means higher velocity of money. That's inflationary. On the other hand, higher prices will help jump start business activities by increasing investment and employment. That will help generate growth.

Now throw in the desire of major external Treasury investors to diversify away from their massive holdings, the odds are we'll see an even steeper yield curve.

Weekend reading: Cautiously optimistic for Q1

What might be in store for the first quarter corporate earnings? For sure, many (perhaps more than 50%) will beat. More important, revenue picture should continue to improve, along with profitability. But most important of all is the outlook. Do companies feel more optimistic about the business, and they will thus invest more and create more jobs?

We'll be reading and watching these outlooks.

Perusing through this weekend's Barron's. Surprised to find something missing: Where is the deeply sarcastic perma-bear Alan Adelson? Has the market advance towards 11000 finally convinced him? Or is he taking a nap? Anyway, it's hard to continue to press for a pessimistic view in front of all the improving economic data and more importantly the markets.

The cautiously optimistic Michael Santoli is alive and well with his continuing caution for a potential correction. This time, we obviously agree. We think Q1 could have some surprises. The generally optimistic mood could have set it up for "buy on rumor, sell on news" kind of trade. But if the fundamental pictures are sound, we should see opportunities in post-earning blues. This is our thinking for raising cash last week.

Santoli mentions China being a factor. We do see RMB rising within a bigger band. The move won't be large. China needs to release some inflationary pressure that has been building up. And to transform itself into more consumption oriented, China should empower the consumers a bit. On this front, the Obama administration seems to be handling it well by pursuing an engagement policy, despite all the protectionistic noise.

If RMB rises substantially over the course of 2010, say another 5-10%, the increased raw material purchasing power should help crude, copper, steel, and other raw material producers. We want to be overweight in these areas.

See Big Picture for an interesting discussion on market sentiment.

It's time to take some profit

Stock market looks very resilient, able to overcome many bad news. Optimism is returning.

Retail sale has been up on consumer strength. Mortgage rate is up too. Gold has been up to highest level for this year.

Some of our holdings are breaking new highs. It has been none-stop since early February.

There is no big concern, but it's important to raise cash at this point. The retail strength noted above could very well be short-lived. So we sold quite a bit of winners, and even started a short position. This sets us up nicely to rotate into the next promising areas.

We hope the upcoming earnings season is going gangbuster. We just don't want to depend on that outcome. If market rises from earnings, we'll benefit; but if vol picks up, or credit risk turns up, or the Fed moves earlier than expected (unlikely) we'll be ready for it.

Consumer credit, Fed concern and rising mortgage rate

The Federal Reserve said Wednesday that borrowing declined by $11.5 billion in February, much weaker than the $500 million gain that economists had expected. The February weakness reflected a sizable 13.6 percent drop in revolving loans, the category that includes credit card debt. On the news, American Express (AXP) dropped nearly 2%.

Consumers are cautious. It's still difficult to find jobs.

In remarks to business people in Dallas on Wednesday, Fed chairman Ben Bernanke said he saw no evidence of a "sustained recovery" in the housing market, noting that foreclosures keep rising. Commercial real estate remains a trouble spot, too.


The toughest problems are in the job market. Even though layoffs have slowed, hiring is "very weak," Bernanke said. He noted that unemployment, now at 9.7 percent, is still close to its highest levels since the early 1980s.

Record-low interest rates should help foster the recovery, but economic growth won't be robust enough to quickly drive down the jobless rate, Bernanke indicated.

The average rate on a 30-year loan has jumped from about 5 percent to more than 5.3 percent in just the past week. As mortgages get more expensive, more would-be homeowners are priced out of the market -- a threat to the fragile recovery in the housing market.

These factors drove down REITs and home builder stocks on Wednesday.

Not sure I should be excited when the Mad Money guy agrees with me

I usually don't watch Cramer's Mad Money. This guy flip-flops too much, and there is too much yelling.

So I was curious to see he has turned bullish on California housing market, even recommending one of my top holdings to play this recovery: Standard Pacific (SPF). He still doesn't quite understand how Standard got here. I don't mean to brag, but there are good reasons to like this company. See my analysis here, here and here.

See CNBC Yahoo report and the video.

(note added on 4/8/10) Cramer was able to pump up SPF by 4-5% or so. Amazing. When he is so bullish, it's about time to take some profits.

Are New Home Sales About to Go UP?

(This article has been published on Seeking Alpha: http://seekingalpha.com/article/196985-are-new-home-sales-about-to-go-up )

Much discussion on new home sales has been focused on how bad the recent sales have been (for example, see this post). March number will probably not be any better.

The rear-mirror view is consistent with high unemployment, sluggish job recovery, abundant supply of foreclosed homes, consumer retrenchment and low household formation coming out of a severe recession.

Looking forward, however, there are signs that point to an upturn, however slow it may turn out to be.
GDP has been growing for the past three consecutive quarters. Much of that growth is underpinned by manufacturing expansion, surge in export and strength in technology. The expansion is spreading to other key industries such as retail, construction, travel, financial services etc. That will add much needed jobs.

Job loss appears to have stopped. And we can now look forward to job growth in the coming months. Job creation is probably the single most important factor that will spur housing rebound.

In a series of recent posts, John Lounsbury has examined analysts forecast for home builder revenues in the next three quarters (see here and there). While his main point is that these estimated revenues appear to be too optimistic, I think he might have identified a turning point for new home sales.

In the table and the graph below, let’s look at the annual revenue picture as a whole for some representative builders, to smooth out seasonality. The data is obtained from Yahoo Finance, or from companies annual reports.

On average, builder revenue has been dropping 30% - 40% for at least three years since 2006. The size of some builders as measured by sales has shrunk over 75% since the peak. The correction has been severe, and rightly so. They should not be building so many houses.

Looking forward, analysts are estimating only a 1.2% increase for these six builders (DHI, LEN, KBH, SPF, HOV, TOL) for 2010 over 2009. And for 2011, the growth is about 18%.

Looking at the graph below, if these estimates are right, 2010 will represent a turning point for new home sales, and 2011 will only see a modest increase.

Going into the recession, analysts tend to over-estimate sales, whereas coming out of the recession, they tend to under-estimate revenues and profits. So I think it is very likely we are at the turning point. The next couple of quarters should see increased home sales year-over-year.

We all know about the problem with foreclosures and the feared “shadow” inventory. Those are the potential supply that may hit the market over the next few years. That may help depress new home sales.

One can argue that there is a countervailing factor, i.e. the “shadow” demand that may materialize as the economy improves. This potential demand is difficult, if not impossible to estimate. But we know there is a substantial population growth in the U.S. and people have been putting off home purchase due to jobs and credit. One interesting area to look at is the household formation.

Household formation in the U.S. historically has been running at about 1.3 million per year. It has slowed dramatically during the recession, to about 400,000 or so in 2009. Young men and women who cannot find jobs tend to go back to live with parents, or share apartments. If employment situation improves, there is a glaring gap of nearly one million new households to be formed. That could definitely help drive up new home sales due to affordability and low mortgage rates.

Another important and overlapping demand factor is from those who have jobs but have been sitting on the fence. If they gain more confidence in the economy and the job market, they’re a ready source of buyers who will benefit from owning homes at a low price point.

In many sub-markets, new homes are not competing directly with foreclosures. It is likely that we'll see warm markets developing while many foreclosure hot spots are still facing huge pressure in the next few years. It is not realistic to think that the excess inventory must be cleared out first before new homes can be built.

Recovery no longer jobless

(This article appears on Seeking Alpha and genrated some heated discussions: http://seekingalpha.com/article/196885-recovery-no-longer-jobless )

Investing in recovery means allowing the possibility for the economy to overcome obvious hurdles. And these hurdles can be huge.

In 2009, bullish investors went after improving credit condition and corporate profits. The biggest worry at the year end was the uncertainty around revenue. Many questioned if the profits were all due to cost-cutting. Soon that worry was relieved as companies reported increasing sales. Nobody talks about that anymore.

Joblessness became the biggest worry, which is deeply tied to consumer's spedning power. Now it appears that worry is going to melt away.

The Labor Department said Friday that employers added 162,000 jobs in March, the most since the recession began but below analysts' expectations of 190,000. The total includes 48,000 temporary workers hired for the U.S. Census, also fewer than many economists forecast.

Most important, private employers added 123,000 jobs, the most since May 2007.

Manufacturers added 17,000 jobs, the third straight month of gains. Temporary help services added 40,000, while health care added 37,000. Leisure and hospitality added 22,000.

Even construction industry added 15,000 positions. This is not surprising given that many national builders have been ramping up community counts and getting ready for the Spring selling season. For example, Standard Pacific (SPF) has made a series of acquisitions of communities in North Carolina recently, targeting entry-level buyers. Construction and selling are expected to start this Spring. Lennar (LEN) has also announced similar activities in North Carolina and Florida.

The employment picture has turned a corner. The gain is not big, but certainly significantly positive.

Manufacturing continues to underpin the global recovery, from China, to Japan to U.S. and even Europe, according to a Bloomberg report:

Manufacturing in China grew for a 13th month and U.S. factories expanded the most since July 2004, reports showed. Business sentiment in Japan rose to the highest since 2008, while factories in Britain and the euro region stepped up production.

The momentum in the coming quarters should accerlerate and spread into more and more industries. A clear sign that the manufacturing expansion is not just an inventory-restocking story can be found in increasing sales from Williams-Sonoma (WSM) to car dealers.

We continue to invest in global recovery.