The Coming Real Estate Recovery -- By The Numbers

I have been analyzing real estate and construction since 1991. I can’t even say that our current real estate collapse is unprecedented, because to me it’s not – I went through the Asian Financial Crisis, and this is like that. As a matter of fact, the Hongkong real estate slump of 1994-95 was pretty serious even before the Big One two years later. And Japan's real estate collapse has been both huge and enduring.

But I well remember my first AFC trip to the region. I had been correctly bearish in 1997 and I was analyzing from afar, unwilling to allow myself to make the trip in case my natural sympathy with people should overcome my brutally harsh analysis. So instead of my usual five-times-a-year Asia trips, I took no trips in 1997. Finally in the first quarter of 1998 I was sure things were as bad as they were going to get, and I did not have to worry about personal contagion any longer. I flew into Seoul, and was driven immediately in a black car to the Bank of Korea. Along the way I saw the debris from anti-government demonstrations and grafitti saying “IMF = I AM F¿¢KED”. The last two hundred yards of the way to the BOK, the car went slowly enough for me to see the sad, sunken faces looking with deep suspicion at a foreigner in a limo on his way to the central bank.

From Seoul I flew to Singapore on a Singapore Airlines wide-body aircraft with exactly three passengers on it, just me and a honeymooning couple.

In Bangkok, I visited the offices of one of the big commercial real estate brokers, where the Englishman in charge appeared a broken man. We looked out over the vast city with its forest of cranes all idle for the first time in memory. “No one will build another class A building in Bangkok for fifteen years,” he said.

But he was wrong. Capital did re-form in the real estate markets, and things were humming again inside of three years.

That’s good, and I expect we can look forward to some similar unexpectedly rapid recovery. But enough talk already. What do the data say we can expect here? Let’s dig into the housing market data.

For a long time I have resisted the popular Case-Shiller 20-City Housing Index, for many reasons. I think Shiller’s nutty professor act is off-putting, as is the false precision in the reports, the short history, and my sense that it is hard to index lumpy and illiquid stuff like houses. But everyone now uses it, so I have to relent.

I refer to short history -- Professors Case and Shiller only reach back to 1987, which misses the booms and busts of the seventies and early eighties. I can’t deal with that, so here’s what I did. I took their data, and lined them up with Census data going back to 1959, data that HUD also reports. I did some regressions and other hand-waving trend analysis to try to extend the Case-Shiller Index back in time.

Hey, if hand-waving is good enough for the Treasury Secretary, it’s good enough for me.

I got GDP, PCE Housing, and 10-year Note Yield data (the latter my mortgage interest rate proxy) from my good friend Fred at the St. Louis Federal Reserve Bank, and lined that up with the housing index stuff reported by the good professors and massaged by me.

Six recessions have been observed since 1959. Twenty quarters (five years) after trough recessionary conditions, the average increase in the price index has been 46.3%, the median increase 55.2%, the maximum 79.8% and the minimum -0.3%.

Eight interest rate spikes over the same period have seen the average price increase 30.0% twenty quarters later, or 34.5% on a median basis. The maximum increase was 75.9% and the minimum -22.3% (i.e. a more than 20% drop, in the period in which we now find ourselves).

There have been only five episodes of declining prices, of which this is by far the worst. Twenty quarters after the midpoint of these episodes, prices are 18.8% higher (average), 17.1% (median), 75.7% higher at best and down 28.3% at worst. But leaving out the current episode, which I suppose is not finished, the figures are respectively 46.3%, 55.2%, 79.8%, and -0.3%.

Food for thought.

Kung Pao Chinese Stocks Ding

I worked in China from 1986-88. People I trained were later instrumental in the establishment of Chinese securities markets. Some of what I did, as theoretical as it seemed then, helped lay a basis for their subsequent development. Before there were Chinese stocks, I owned Chinese bonds. When the first issue of Chinese shares was offered to foreign investors, China Southern Glass in 1991, my company bought in.

I have been involved in modern China’s financial system since before its creation, and stayed involved continuously. So let’s declare biases honestly and note that I am not impartial. I am called a China hand by my Chinese friends, and dismissed as an apologist by . . . others. I’m not a dreamy China head (though I did go through that dreamy China head phase for about three weeks in 1986). I am sharply critical of what I see as deficiencies of their system.

I have been fortunate to make money in Chinese financial markets. Sometimes it has been a simple matter of doing the diametric opposite of whatever the top Wall Street firms advise in their China strategy. But when they have gotten it right and their clients have done well, as during the latest Chinese bull markets, it has been a wonderful thing to see. I’m glad so many people have good success, because in the 90s it sometimes seemed that everyone who ever invested in China lost money and ended up sour on the experience.

Certainly there have been problems that have bedeviled the Chinese markets all these years.

As a nominally communist country, China struggled at first with the very concept of financial markets. When they began to be introduced in the late 80s, they were described as “experimental.” The designation endured for a long time. It is not much of an endorsement, is it? “Welcome Capitalist Roaders to Invest in Our Experimental Markets that We Might Shut Down if We Don’t Like the Way it Goes.”

If markets were purely experimental, the social scientists running the experiment figured they might as well do lots of trials. To that end, the Chinese markets have been finely sliced and diced like Kung Pao Chicken Ding. The authorities set up a Shanghai A share market for local people and a Shanghai B share market for foreigners. Then they replicated the pair in Shenzhen – that’s four venues in China for the trading of Chinese shares. Two classes of Chinese shares, the H shares and the Red Chips, traded in Hong Kong. There were N shares, for which the initial listing was on the NYSE – China Brilliance (CBA), Shandong Huaneng (SH), and Huaneng International (HNP). Later they lost control of the process, and various stray Chinese companies did IPOs in Singapore, Tokyo, Sydney, London, and I lose track of where all else. There has been a major boom in backdoor listings of Chinese companies on junior stock exchanges around the world.

And that’s a big problem – no one can keep track. If I want Italian shares, I pretty much know where to look. If I want Chinese shares, where do I start?

(I met a Chinese market regulator, an executive of the Chinese Securities Regulatory commission, in May 2007 during the raging bull market. He was in a self-congratulatory mood, and invited me to offer congratulations too. I demurred, and instead took the opportunity to point out that their sclerotic regulatory process had prevented too many decent Chinese issuers from doing IPOs in the Chinese markets where home-team investors would most welcome them, sending them instead to go for Rube-Goldberg RTO and SPAC listings on junior stock exchanges abroad where they would struggle to gain a following or a fair valuation.)

The B share markets in particular became bogged down in a morass of low liquidity and poor quality. There were a few corporate governance issues. Many foreign institutions believed that the Chinese securities market experiment was designed to let the Chinese government move garbage off its books into foreign portfolios. I have had big investors tell me with a straight face that they assumed the Chinese meant to hose them.

Some of the international stock offerings have had that effect, but I don’t believe it was ever intentional or malicious. The Chinese thought they would impress us by making their biggest enterprises available to us – their giant steelworks, shipyards, and petrochemical complexes. It turns out that bigger is not better. The social burdens on these cities-within-factory were hard to lift.

It can be quantitatively proven that the closer a share gets to the domestic Chinese investor the better the average quality, if such a concept can be distilled from growth rates and balance sheet items. H shares that do not also list A shares are worse than H shares that do, and A shares that do not issue any class of share to foreigners are of the best quality. I have done the work on this. I’ll report the research in this space shortly.

More than one fund manager has rejected my research finding, without offering to rework the numbers. But the alternative is to believe that they have sold us better stuff than they sold themselves. Does that make sense to you? No, it is intuitively hard to accept. It could not be, because whole attractive parts of the Chinese economy, including retail/wholesale trade and part of the telecom and media space, have been off limits to foreign investment in the past or even now. That alone would raise the quality of the average domestic Chinese share, and it has nothing to do with the Chinese government going out of its way to dump its garbage on foreigners.

If you run an international mutual fund, then the Chinese markets are just one part of your opportunity set. Given that they are sliced and diced beyond comprehension and riddled with pockets of low liquidity and poor quality, you could always make the case that it’s more bother than it’s worth.

But if you are a domestic Chinese saver, then Chinese A shares are a huge part of your opportunity set. As a Chinese investor, what alternatives do you have? Interest rates on bank deposits have been reduced from 24% to very, very small, bonds are not popular, and real estate is relatively illiquid. And some of the stocks in the opportunity set are really good after all.

For most of the time, this fact has eluded detection by the so-called experts of Wall Street, who have not generally examined domestic Chinese shares as long as they remained off-limits to their international clientele. But one feature of this latest bull market has been that some foreign investors are gaining access to the domestic Chinese opportunity set, while some Chinese investors are venturing abroad. That means Chinese investors, at least the biggest exemplars of the breed, are now clients of Wall Street, and Wall Street had to open its mind and its eyes and assign some analysts to take a look at the A shares.

Formerly, when the A share markets have gone crazy on the upside every once in a while, the foreign brokers who ostensibly “cover” Chinese markets have had nothing to say. These periodic bull moves have been totally incomprehensible to them. Don’t they just prove how stupid and gullible the Chinese individual investor is? Well, no . . . there has been another obvious conclusion, but these foreigners have not always had enough information to arrive at it. That conclusion is: some domestic shares are good, and there is a time and place to buy them, if you can.

China is complicated. More than once I have had to argue with analysts over points of fact – not opinion, fact -- arguments of the Kafkaesque “Black is white” variety. Well, the facts are sometimes obscure. So who does Wall Street send to deal with this most confusing and delicate market? Often its youngest, least experienced, least capable analysts, of course! Since China is relatively speaking a small part of the global opportunity set, why send a top gun analyst? You need that guy back in Hongkong to write the thirtieth report this week on HSBC.

So what is changing these problems? The passage of time. The action of price, making China a bigger piece of global market capitalization, bringing in more investors in the good times and lately attracting more critical scrutiny in the bad. How about regulation? The financial markets’ place in modern China is not the subject of an experiment anymore. They are clearly here to stay. With this belated acceptance the worst of the slicing and dicing should be undone. Short of allowing A and B share markets to merge, the regulators can easily allow domestic investors to gain access to B and H shares and expand foreigners’ access to A shares. My sense is that China emerges from the current global financial crisis with its relative position enhanced compared to other economic players. It has national savings, it has surpluses, it can adjust policy at short notice. Sclerosis now is a bigger problem for the developed west.

I still hope for root and branch restructuring of the regulatory system that allows these changes and many others to come more quickly. But my CSRC official as well as many other Chinese advise me not to hold my breath. Even though it is a relatively new bureaucracy, it is still a bureaucracy, and an entrenched, calcified one at that.

Note the political theater aspect of some of the economic discourse

In this trading week, the DJIA has been down 300+, up 200+, and as I write this note, down another 200+.

A significant part of Tuesday's drop occurred during and after Barack Obama's inaugural address. Whether you were wowed by the address or not, you have to admit there was a lot less gaseous uplift than we have come to expect from his speeches, and a bracing amount of sober description of the economic problems we now face.

There was also considerable weakness during our up 200+ Wednesday, as Treasury Secretary nominee Tim Geithner was telling the Senate Finance Committee confirmation how gravely serious these problems are.

Unquestionably, there are real difficulties now, but it is necessary to bear one thing firmly in mind when the new president and his administration talk down the US economy. This is necessary and effective political theater. Now that they have taken ownership of the situation:

1) The new administration has to blame everything on the old administration.
2) They have to accentuate the old administration's responsiblity for all problems, so that they can take full credit for their remediation.
3) They have to set low expectations that they can expect to exceed.
4) And they have to enhance the crisis atmosphere, because that is the environment most receptive to their proposals for radical action.

I recall dark days during the Asian Financial Crisis, one of the several hundred-year floods I have experienced in an 18-year financial career. It was Christmas week, 1997. In Korea, Kim Dae-Jung won the election to succeed Kim Young-Sam, and the next day he made his inaugural speech. In so many words, this what he said: "Wow. Holy $h|t. Things are way more screwed up than even we thought. I don't know whether we are going to go bust tomorrow or the day after tomorrow."

The KOSPI did another belly-flop off the 10-meter board. But recognizing the speech as just great political theater rather than pure reasoned analysis, I thought that market break was buyable. And that buy turned out very well indeed.

If the theatrical elements follow the same script, this market break may also turn out very well, or so I may, ahem, hope.

The administration has a fine line to walk, however. They want to pursue the script only far enough to meet their political objectives, but not so far that everyone takes an even greater fright than they already have, killing confidence and tipping the economy into a depression from which it can't be pulled out.