Michael Shulman's Sell Short

Market conditions make shorting the home builders and their cousins - suppliers, Home Depot et al - very difficult in the short run. In the long run, housing in the US will be permanently different, the ongoing profitability of these companies is in question and several of these outfits are going under. For sure and for certain.
Housing is a wreck and compared to market expectations, getting worse. Why does this matter so much?

• Housing has been, for more than two generations, the segment of the economy the Fed could manipulate through interest rate management and in turn stimulate the economy when needed. This is no longer the case -- even with recent increases mortgage rates are very low, with no discernible impact on the sector or economy.
• Housing, for the past two decades, had been a growing source of credit for consumers and in the pat five years was virtually the piggy bank of the consumer through the increased use of home equity credit lines. This is no longer the case - with so many homes under water; 67% of mortgage holders have less than 15% equity in their homes at yearend 2008 home values, credit standards are tightening and banks are, in general, pulling back.

• Housing continues to be the largest single component of credit exposure for banks quasi-banks, government supported banks and any other bank you can think of - and the quality of these assets is declining minute by minute. As long as housing suffers, and asset quality not only does not improve but declines, the banks will continue to reserve too little and lend too little to add to reserves.

Why do I think housing is in the tank for the long term?

First, I listen to people smarter than I am - a key to success from investing to recreation league baseball. When my rec team had its first losing season - after twelve consecutive great seasons (two per year) I did the logical and hired a professional coach. They were winners the next season. Ditto for analyzing stuff - and I follow Ivy Zelman (http://www.zelmanassociates.com/default.aspx) and Whitney Tilson (http://www.tilsonfunds.com/). They have been dead on about the mortgage meltdown - and see a larger one coming.

Listening to them, reading data ad being objective has led me to see the key to a rebound in housing is clearing inventory - too much supply and too little demand, and since lower than five percent interest rates have not spurred buying, supply is the issue. Supply comes from the sale of existing homes; the sale of new homes; and the sale of foreclosed homes.

• Typically ten to fifteen percent of Americans sell or want to sell their home in a given year. Recent survey data shows the number is now 30%. Keep that in mind.

• New home sales are incredibly low. Market wisdom said home building stocks would rise once the new housing start rate hit a million and inventory became tight. New home starts are roughly half of that and there ain't no rebound. As the poet said, times, they be a changing.

• People are not selling, and builders are not building, not just because people are not buying - it is because prices are low and going lower and the driver here is foreclosures. Data can be fond here, there and everywhere but the salient data points are a) banks are accelerating foreclosures b) the next wave of resets of mortgages, the cause of most foreclosures, does not peak until the summer of 2011 c) banks are already sitting on more than half a million homes they have not listed for sale and the whopper is d) the New York Times has reported that there are nineteen million empty housing units and only six million are listed for sale.

This last point, when combined with another couple of million foreclosed homes, then with desire for people wanting to sell their home as soon as they can, means excess inventory for as far as the eye can see. I originally projected housing prices would, nationally, bottom at the end of 2011 and prices would begin to pick up in mid 2012. I may have been premature. With resets peaking in mid-2011, defaults will probably peak in early Q4 2011; this means foreclosure listings will peak in mid-summer 2012, after the peak selling season, not good for managing down inventory. Assuming demand picks up - a near heroic assumption at this time as interest rates will be higher and unemployment could be the same or higher at that time - you will start to see inventory declining in a meaningful way until 2013 at the earliest.

I have focused on supply - was I too cavalier about demand? Well, that is more problematic - resets, defaults and foreclosures are fourth grade math and although the only thing I knew about housing was my own mortgage before this mess started, I can do fourth grade math and very forecast I have made about foreclosures and inventory has been right within a 30-45 day period.

Using fourth grade math as our primary tool does have value in estimating demand. Roughly 40% of demand in the peak year - 2006 - was sub-prime or near sub-prime - and these buyers are out of the market for a considerable period of time. And a very large percentage - some analysts estimate as high as a third - of all sales were for investment and second homes. Most of this demand is gone for the foreseeable future. Add tightening credit standards, recession ravaged incomes and personal balance sheets, and a new frugality and it is hard to see demand in 2013 or 2014 climbing past 50% of demand in 2006. Even if the FHA does not go bust - which it will, requiring another Treasury bailout.

You will notice I am not using specific point estimates - that is an analyst's game. I am a stock picker and options guy - mostly on the short side. And I make recommendations based not on absolute values nut change - the relative movement of a stock or segment against other segments, the market and Wall Street expectations.
I recently had lunch with a very smart - truly - Wall Street type economist who mostly follows Uncle Sam and his cousins for institutional clients - and he is very good at what he does. He has been doing this for thirty years and I made this argument. He disagreed, I laid on the New York Times reported estimate of thirteen million vacant, unlisted dwellings and he laughed, waving his hand - and then stopped himself. "You know, I own two places that are vacant, I will sell but have not listed because prices are too low. My old place at the beach and my mother's place in Miami." Not investment properties - just properties waiting for a market comeback.

He also predicted the economy would bottom in Q4. We were having lunch at the Palm and as we left he looked around - it was a Thursday, second busiest day of the week - and noticed something. "I have never seen this place so empty." I punched him lightly in the arm and said, "can't wait for that recovery pal."

So, what to short?

Short term, traders are beginning to get weary of waiting for a rebound and short interest in many homebuilders is increasing driven this week by the sharp rise in mortgage rates. So, pick a publicly held homebuilder and take a look at the chart. Toll Brothers (TOL) and KB Homes (KBH) have weak balance sheets the shorts like. Longer term - two to eight quarters - play almost any of them or buy puts on the homebuilding index, the XHB.

Their suppliers have been crushed - Louisiana Pacific (LPX) and Masco (MAS) are the two big names. Check them out also - short interest is increasing and Masco's net cash - cash plus liquid securities plus accounts payable (assuming they will be paid) minus accounts receivable - wouldn't fill my gas tank for too long.

TARP money was repaid this week - the FDIC said the purchase of toxic assets from banks is on hold - health care reform is now going to be built around mandatory health insurance - Hezbollah was defeated in Lebanon, perhaps foreshadowing a change of tine from Iran - gasoline hit $2.85 a gallon in my neighborhood - national chain store sales fell 4.4% last month - Obama said the stimulus was working too slowly and now he wants to create 600,000 more jobs on top of the jobs that have yet to be created -- mortgage rates climbed a full point over two weeks ago -the Supreme Court suspended, for a bit, the purchase of Chrysler by Fiat - and with all of this the market went sideways, Just another week in The New Normal. The equity markets sighed, then yawned, and action moved to commodity markets - especially oil and gas, - then to government bonds. The markets must have known I am trying to get to London this summer and bid down the dollar against the pound.

Think about it - all this news, any of it mind blowing and market cracking a year ago - and now we accept it, reminding of something a science teacher taught me way back when. If you put a frog in hot water, it jumps out. If you put a frog in room temperature water, and slowly heat it up, the frog stays there and boils to death. The markets are behaving like frogs right now - each week, news gets hotter and hotter, worse and worse about the economy, but it does not seem so bad, so the market either stays put or goes up.

Is the water eventually going to boil? Ask the consumer.

They will tell you - we are broke. And getting broker. And consumers that are broke, feel broke or afraid gong broke do not spend money - or as much money as they used to. Given that 65% to 70% of the US economy depends on consumer spending, the broke consumer means a broken economy.

In the 1970s federal law changed and said banks could charge interest in credit cards up to the rate allowed in the state where the bank ostensibly did business. In a nanosecond the banks found high interest rate states - ever wonder why your Citibank Mastercard is issued in South Dakota? - and the credit boom was on. Fast forward to 9/11 and the president, rather than raise taxes to pay for a war or two, told us to shopping, with credit of course. To buy stuff probably made in China. And by the end of last year the American consumer had amassed more than $13 trillion in debt - or more than 130% of disposable income, on average.

Well, if you don't want to use credit, spend some of your accumulated wealth. What wealth - the recent meltdown in hosing and equity markets has reduced personal wealth by roughly $13 trillion and the number is climbing. The psychological toll is greater - you feel poorer because you are, and you probably feel worse than you really are, and you pull back on spending.

Well, if you don't use credit or wealth, use your current income. What current income? Unemployment is 9.4%; real unemployment, including the discouraged and part timers wanting to work full time, is almost 20%; hours worked per week are falling; and after tax personal income, or the nation, is falling.

Well, get some more credit card and hope for the best. Not an option - banks are on a pace to pull back more than $2.5 trillion in credit lines this year. Re-finance or increase that home equity line. Nope - 67% of mortgage holders have less than 15% equity in their house and that number is falling alongside home prices.

One last note -- gasoline hit $2.62 nationally this week, up a buck in the past 12 months.

OK - no credit, fallen wealth, falling incomes rising gasoline prices. And in the face of all this, what has Wall Street done? The XLY - the Exchange Traded Fund representing consumer discretionary spending -- and the RTH - the Exchange Traded fund representing retailers - are both up year to date. The Street is expecting and pricing in a recovery from the bottom - which we have not reached - and I cannot tell you where they think the consumer will find money to spend.

Think head fake - momentum feeding momentum - and a bear trap if ever there was one. Is there a trade here? An investment? Not yet - the momentum has slowed down but this trade - consumer led economic recovery - is still in play, a game for very short term traders. Stick with fundamentals and wait - when the Street wakes up, there could be a great opportunity on the short side to make money on the whole segment through an ETF or the purchase of puts on the ETFs mentioned, the XLY and the RTH.

Specific names? Look for companies that were in deep yogurt before the consumer went broke. Two come to mind -- classic, long term shorts - Sears (SHLD) -- and the GAP. Been in a Sears lately? Been in a Gap lately? Even a consumer rebound -- the one that is not coming -- will leave these two gasping for air. Sears will spin off or sell K Mart, Gap will spin off or sell Old Navy, in last gasp moves, perhaps one to two years from now and then, nothing.

Among the luxury retailers, check out Coach (COH) -- good managment, too many stores, not one product anyone has to buy.

Green shoots has become a tiring term - clichés in the age of new media really run of out of gas quickly - and I recently took a two week working vacation to dig out green shoots for my readers. Data is nice - but you can get that anywhere and it basically starts arguments. So I told myself to take a hard look on the ground? What did I find? Brown shoots everywhere.

The two weeks on the road were spent in very different economies - the "posh" but understated part of Long Island, the North Fork; Hartford, Connecticut (family); Maine (need to eat some serious fresh lobster); Nova Scotia (gorgeous); Maine again (got to get back home); and then four days in New York City including a book part for my new title, Sell Short.

What did I see? There were two or three other guests in my luxury hotel in Greenport, empty restaurants with great food. We had no problems walking in to one of the most popular restaurants in Hartford; ditto for the most popular lobster in Bar Harbor (I copped out and got a small one but I did manage to ruin my shirt); a near empty hotel in Nova Scotia, one of the three luxury resorts capitalized by the Canadian government and the most popular destinations in prior seasons. And in Nova Scotia, same day reservations for a special whale watching exhibition in a zodiac that only holds a dozen nerdy tourists. Driving back through Maine, I stayed at a Wyndham in Portland filled with airline personnel and no one else, across from the very, very empty Mall of Maine. And I concluded my trip at a very busy Hilton in New York - busy, busy you say? - filled with tourists taking advantage of radically discounted priced rooms, buying what was available at the half price theater ticket booth or just walking the streets. We found same day tickets available for almost all shows, including for Mary Stuart (terrific play) and In the Heights (great musical, hottest dance chorus since Pippin, yes, I am that old). All of this during tourist season.

And a book party with guests from all parts of the economy, all discussing an uncertain future and all pulling in their spending. Except for the teacher at a prep school and the television producer working the Bernie Madoff case.

Are anecdotes worth investing in? Just as Peter Lynch - you can start with these anecdotes - but first you must ask yourself why is Wall Street so adamant about green shoots and the "bottom." Simple - Wall Street is congenitally biased to the upside, we were coming off a very sharp decline in the markets and Obama has a great ability to lead, convincing us and then remind us the world is not ending.

So, are we at a bottom? Perhaps - but my concern, my observations are about the lack of a rebound. And the current market is now beginning to look for signs of a rebound. So brown shoots mean a lot as the market starts looking to Christmas and beyond.
The tricky part is the definition of a rebound. I read this morning about the big turnaround in auto sales - they are "only" going to be down 20% at Ford and call option activity is accelerating (I am long, in my service, Ford calls). Turnaround? A year of 55 million in sales with worldwide capacity to make 100 million cars? The auto industry is representative of the debate - we may bottom at 55 million but when will sales support current stock valuations? And that is true for most if not all consumer discretionary stocks, from Tiffany to the Cheesecake Factory.

So, short term, you can play the short term optimism - as I said, I am long Ford in my service - but what about the longer term?
For a longer term trade, assuming you agree with me and the summer will be a bust, so look to short travel related stocks. And if you sense Christmas will see Santa stuck in the chimney, look to short names that people will continue to trade down from - Cheesecake Factory, P.F. Changs, Macys -- - avoid names people will trade down to - Dollar Tree, Wal-Mart, Darden (Olive Garden). Look for real discretionary spending stocks - Harley Davidson, Tiffanys, Coach, Nordstrom - and look for underpriced products that will see increased demand in the winter - natural gas (the UNG).