Monday, February 25, 2013

Will the snake-bite effect hurt housing?

Since the Fall Melt-Up of 2011 began, homebuilders have been on absolute fire. After being a drag on the economy and deflationary headwind for many years following 2006, a recovery seemingly out of nowhere began to take hold.

Efforts by the Federal Reserve to lower longer-duration rates through a combination of Operation Twist and quantitative easing sent mortgage rates to record lows with the goal of pushing demand and prices up. By targeting the wealth effect, the hope all along has been that rising asset values would cause a pickup in consumer spending, helping to shift the economy into accelerated growth.

"I like to keep a bottle of stimulant handy in case I see a snake, which I also keep handy."

�W. C. Fields

In theory, there is some logic to this. With housing inventory at its lowest since 1999, it appears to no longer be a buyer's market. Many have argued that another major trend higher in housing is now likely. While this certainly is possible, I question whether the Fed's efforts can counter the memory of the housing bust in terms of making a prolonged period of strength in housing likely.

Oftentimes, when an asset class goes through a bubble, it tends to exhibit lackluster performance afterward. Much of this can be attributed to something in behavioral finance known as the "snake-bite effect." Once bitten, twice shy means that money rarely chases that which caused major losses as the memory of that loss remains too fresh. Bubbles in one asset class don't tend to reoccur because of this, at least not until a new generation of money with no memory of the past calls the shots.

So while housing does appear to be recovering, the pace of strength might not continue to be as strong as many in the financial media seem to think.

Take a look below at the price ratio of the SPDR S&P Homebuilders Index ETF XHB �relative to the S&P 500 SPY . As a reminder, a rising price ratio means the numerator/XHB is outperforming (up more/down less) the denominator/SPY. For a larger chart, visit https://twitter.com/pensionpartners/status/305862599910764545/photo/1.

It has been an incredible run of leadership since late 2011, and outperformance in homebuilder stocks was clearly an indicator of U.S. strength, with the benefit of hindsight in the face of a global growth slowdown.

Notice the far right of the chart, where a breakdown appears to have occurred. A lot of good news may be discounted now in homebuilder stocks, even though inventory is so low. With nearly everyone apparently now of the belief that interest rates will only go higher, there might be a cap on strength in the near-term.

I do wonder if this becomes a trend, however. If homebuilders are on the verge of weakening in a meaningful way, it would seem to be curious timing given the various other inter-market trends I have been highlighting since Jan. 25 signaling that a deflation pulse is beating with the idea that a potential correction is coming for risk assets.

On CNBC Friday, I re-iterated the idea that behaviorally it does look like some kind of a correction is happening. With the sudden weakness in homebuilders, it would make sense that any kind of market volatility results in money selling off the winners aggressively to book profits.

Our ATAC models used for managing our mutual fund and separate accounts have continued to be defensive, with no changes in terms of staying in bonds. Weakness in homebuilders may be warning that rates have gone up a bit too far too fast in the near-term, which could then in turn actually mean rates fall from these levels.

This could end up being a very telling time for the industry. Was the move simply a well-deserved major bounce following years of weakness due to central bank action, or is this the start of a prolonged period of leadership where underperformance does not last long? I suspect the snake-bite effect will be much harder to counter than most realize.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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