U.S. Real Estate No Longer (That) Attractive

Note: In our July 31, 2013 post (see “Our Revised 12-Month Outlook on Major Asset Classes“), we downgraded Developed Equities from a return rating of “5” to “4.” Since then, the Dow Industrials and the S&P 500 have declined by 4.4% and 3.1%, respectively. Meanwhile, our upgrade of Emerging Markets was based on valuations. With the exception of India, Indonesia, and the Philippines, EM equities have done okay (Chinese equities have risen since July 31). Note that in general we never advocate any long positions on the weakest links–those being India, Vietnam, and probably Indonesia right now.

Please also note we will also never advocate any substantial long positions in an asset class that led the last bull market. E.g. We did not advocate much buying of tech stocks during the 2003-2007 bull market. Rather, we advocated the purchase of precious metals, commodities, etc. As a rule, the asset classes that led the last bull market (those would be U.S. real estate, U.S. financials, EM equities, and commodities) typically under perform in today’s bull market. Already–based on our deal flow and conversations with clients–we are seeing green shoots and revolutionary, but practical breakthroughs in the U.S. technology sector. We believe U.S. tech will lead the current bull market to new heights over the next several years.

In the meantime, both U.S. and global equities are undergoing a corrective phase. Based on our proprietary technical and sentiment indicators (which we will cover in latter commentaries), they are still not close to a buying point. We expect this corrective phase to last another 2 to 3 months. We also expect the U.S. and global economy to slow down for the rest of the year, given increasing anxiety over the uncertainty of U.S. monetary policy, the change in the Fed chairmanship (most likely, Lawrence Summers will head the Fed, which will not be constructive in the short-term), and uncertainty over the Chinese and Indian economic slowdowns.

We believe U.S. real estate–despite its recent positive momentum–will suffer a slowdown as global investors pull back, and as U.S. interest rates continue to rise (this morning alone, the 10-year Treasury rate spiked by 15 bps to 2.9%). Since the beginning of this year, we had given a return rating of “9” to U.S. commercial real estate–our most bullish return rating this year thus far. Both U.S. commercial and residential real estate prices have significantly over-performed this year–reaffirming our bullish view. Keep in mind, however, that our bullish outlook on U.S. real estate was predicated upon: 1) ongoing monetary stimulus, 2) severely oversold valuations and dislocation in U.S. real estate, 3) an undervalued US$, which generated significant foreign interest, 4) a re-allocation by institutional investors (e.g. pension funds and sovereign wealth funds) to U.S. real estate from other global risk assets. Given the heavy investment activity and the rise in U.S. real estate prices this year, we are no longer as bullish. In addition, the recent spike in interest rates, including the 30-year mortgage rate, is generating significant concern among CB Capital.

30-year mortgage rates

The recent spike in the 30-year mortgage rate (on a % basis) is the most severe since the spike during summer 2006, which preceded the bursting of the U.S. housing/mortgage bubble in 2007. We are not as concerned this time around (we went short U.S. equities in late 2007) as the U.S. housing market–unlike the typical post WWII economic cycle–did not lead the U.S. recovery over the last several years. However, the history of the above chart cannot be ignored. As such, we are downgrading our return outlook on U.S. commercial real estate–from a “9” to “8,” and increasing our risk rating from “5” to “6.” We would also not be surprised if some kind of financial “dislocation” emerges in other parts of the world, such as India, Vietnam, or even the Euro Zone. The last time we witnessed a combination of spiking interest rates and Fed uncertainty (i.e. 1994), Orange County filed for bankruptcy, and many investment banks and hedge funds lost substantial amounts betting on the carry trade. Investors should dial back risk-taking in general for the next two to three months.

12-month Outlook September 2013

%d bloggers like this: