A Good Week for the Market, Finally

You know what we haven’t talked about lately? Residential real estate. Why is that? Because residential real estate is dead. It has been dead for about 6 years and isn’t getting any livelier. Well, maybe it could be. Let’s explain.

The trouble with residential real estate was that it got far too expensive given its economic utility. We will define its economic utility as the rent it could fetch. When a house cannot be rented out for enough money to carry the mortgage, pay the taxes and yield some small pittance to the investor, it isn’t likely to go up in value. We got to the point where with funny money mortgages, you could get a home for zero down, artificially low monthly payments for the first few years and maybe even interest only for a long time. That made no sense from the lender’s point of view, but they were just going to dump the mortgage on some unsuspecting investor in the guise of a mortgage-backed security anyway, so they didn’t care.

Then, when prices stubbornly kept rising, it became a strong belief that the game was rigged in favor of the buyers, and everyone wanted to get in on that side of the deal. Prices went up and everyone was happy, until prices stopped going up. That in a nutshell was the real estate bubble.

But, today we have a different set of circumstances in many parts of the country. Home prices have fallen, often quite dramatically. With interest rates very low, it is often cheaper to own than to rent. But, with credit hard to come by and the prevailing notion that prices will only go down, no one wants to buy. Except, maybe investors.

For the real estate investor, today isn’t such a bad situation. If they can pay cash, they can call the shots. Banks and other folks stuck with foreclosed real estate want out and are what they call motivated sellers. Cash will talk with those guys. Many properties won’t appraise at close to market value because appraisers have gotten tired of being sued for overly optimistic appraisals, so they err on the side of conservatism. It is hard to get a loan unless there is a huge down payment creating substantial equity in the property. Investors don’t have this problem either.

With hurdle rates from competing income alternatives at very low levels these days, the return to the investor from rental income can be quite compelling. Unlevered returns in the 5% to 6% area are achievable in many markets across the country. Toss in a little leverage and you might make it to 10%.

Does this mean property prices will stop going down? Probably not right away, but it will help. Real estate is a capital intensive endeavor. There is a lot of unemployed capital in money market funds and bank CDs earning almost nothing these days. It seems like a match made in heaven. But, so long as the general real estate market is uncertain, there will probably not be a stampede of investors trampling over each other to get into it. But, it is a start.

Issue of the Week

It isn’t often we get to talk about Slovakia, a tiny country wedged between Poland and Hungary, and formerly part of Czechoslovakia. This small nation held Europe’s future (well the Euro’s future) in its hands last week when its parliament defeated a bill to expand the powers of the European Financial Stability Facility. The EFSF is the main bulwark against contagion in the Euro area. It will help stabilize banks when the sovereign debt crisis becomes a sovereign default fact.

The Slovaks voted the deal down when the ruling coalition made the vote essentially a no-confidence vote in the sitting government. That made the deal harder to get by and led to the vote against. When the ruling coalition agreed to have new elections to establish a new parliament, the second try at approval passed with many opposition parties joining most of the ruling coalition in approving the measure.

The G-20 (a group of the leading industrialized and developing nations) meets in France this week to put pressure on the Europeans to solve some of their many problems. It will be the G-20 nations that hold the key to bringing new weight to bear on the issues. The developing countries in the G-20 have the resources to help the weak European debtors avoid default or at least manage a default more easily. They can make loans to or buy bonds from the EFSF or other parties to help grease the wheels of progress. Or they can sit back and wait and let the whole house of cards fall in on itself.

The developing market countries and their central banks have been major players in this drama lately as first the Brazilians and later the Chinese made entreaties to the major European nations. Brazil offered to buy Italian bonds and the Chinese offered to lend money to the European Central Bank.

Supposedly, the emerging markets have a vested interest in keeping the entire world growing and prospering. By staving-off a global financial crisis, they keep their economies humming and growing. We’ll see.

Economic News

Job openings declined to 3.06 million in August from 3.21 million in July. Separations, people quitting their jobs or being laid-off, were 3.67 million in August, slightly higher than the July number. The total number of hires was 4.01 million, again higher than the 3.98 million in July. What this shows is a much more dynamic job market than shown in the monthly Employment Report, which only shows net changes from month to month. When roundly 4 million people get jobs while roundly 4 million people lose jobs, it doesn’t sound quite as ominous as no one getting a job over the month.

The US Trade Deficit was largely unchanged in August from July at $45.6 billion. That’s probably about as good as trade figures get these days.

Retail sales jumped 1.1% in September from August. The gain was pronounced in automobile sales, which gained 3.6%, but was pretty strong across a wide swath of goods. A good back to school season helped, but seasonal adjustments should have accounted for that. Retail sales are 7.9% higher than a year ago, unadjusted for inflation.

Consumer Sentiment from the University of Michigan and Reuters declined to 57.5 in October from 59.4 in September. Most economists had expected the sentiment number to follow the confidence number posted last week that showed a small gain. Oops.

Weekly Stuff

Risk was back on last week with seeming improvement in the European sovereign debt situation and a stronger domestic economy in the US. Who’d have thunk it?

Stocks rallied multiple percent in what could have almost been called a buying stampede. We suspect that a lot of short covering and asset allocation drove the prices. Buying was focused on increasing risk as small caps gained more than large caps and emerging markets beat-out developed markets.

It was not such a good week for bonds. Treasury bond prices declined almost across the curve as the safe haven was abandoned in favor of casting our lot with the risky side of the market. Foreign sovereigns slipped around the world, with the only exception some emerging markets. High grade debt pretty much followed Treasuries lower but high yield debt soared with stocks.

The real estate area was strong with foreign and domestic both rising multiple percent.

Commodities have been very funny lately. Take for example the spread between a barrel of Brent Crude and a barrel of West Texas Intermediate, which for years had a spread of between $0.75 and $2.00, due mainly to transportation costs between Europe and North America. That spread today is at some sort of record of $24. Why, we can’t fathom. There is no real shortage of light, sweet crude in Europe since Saudi Arabia has filled that vacuum with cheap Arab light. The output of Libya will be coming on in the next few months as repairs to the infrastructure there proceed. But, folks must think they need Brent crude. There might be some huge short that has to cover. Overall, commodities have rebounded with everything else.

Have a great week.

Karl Schroeder, RFC, CSA, CEP

Investment Advisor Representative

Schroeder Financial Services, Inc.