It’s been a while since we’ve looked at real estate.  It’s still a very quiet, anxious market, but a few things have changed quite dramatically in the last year.  We can now point to some new trends that are more clearly establishing themselves.

This week I have a couple of new items to add to the discussion.  If you’ve been thinking about buying a house, some of this discussion may be helpful in determining whether you’re in a state where you can take your time buying a new house or one in which you might want to think about acting a little more quickly.

We’ll get to all that in a minute.  First, we need to do a quick market update and outline a clever equity strategy that you might enjoy.  I think the strategy has a  good chance at outperforming the market over the next decade with less volatility to boot.  And the best news is that anybody can do it.  Even you, mom!  And if you drop it on your buddies at the next club cocktail party, you’re going to sound really smart.

Market Recap

It’s a new bull market high!  Last week the S&P 500 finally closed above it’s previous high of 1365.  You guys all know that this was a level I’ve been watching very, very closely.  In the world of technical analysis this level is a big deal — it’s the previous bull high and crossing through it means that the correction that began last May is officially over.

A couple weeks ago I outlined a low risk / high reward trade to short the market.  That trade is over.  This was the out point.  We talk all the time about clearly defining your parameters before getting into the trade and it makes managing bad trades much easier.  I hope you’re not looking to aggressively short this market right now, but if you are, I hope that you are a smarter guy than me.  I’m not saying it can’t be done; I’m just saying that I don’t have a sensible way to go about it.

If you’re scratching your head over what to do about this market, my suggestion is to make peace with the medium-term bullishness.  Accept it.  My favorite thing in the world to do is look for stuff that’s cheap.  You can do this in any market environment.  Right now, the stock market as a whole is either cheap — if you’re looking at 2013 forward earnings — or expensive — if you’re using some flavor of normalized earnings.  So who knows.

I’m a lot less excited about the market as a whole than I am about individual companies and sectors.  Nothing is as cheap as it was a couple of months ago, but there are still plenty of quality companies out there trading at very reasonable multiples.  A lot of them pay decent dividends, too.  And that’s something you can always get excited about.

A Snappy Strategy for Stock Shopping

If you’re a trader, I’m sure you have plenty going on.  But if you’re a long-term investor who may also be looking for cash flow, feel free to look at some individual stocks.

When looking at what kind of companies to invest in, ask yourself three questions:

1. Does their dividend yield more than the 10yr U.S. Treasury Note?  (bonus points if it yields more than the 30yr!)
2. Is their balance sheet cleaner than the U.S.’s?
3. Are they going to grow at a rate greater than GDP in the next decade?

There aren’t that many companies that satisfy those three criteria, but there are enough that you should be able to put together a big enough shopping list to draw from.  I think that if you build a diversified portfolio of those types of companies you’ll outperform the market over the next 5-10 years, and I think you’ll do it with less overall volatility.

The bad news is that it’ll take some discipline.  There will be windows where that kind of portfolio will get outpaced by riskier stocks and there will be periods where the entire market is melting down and everybody starts asking scary, existential questions.  But when it’s all said and done, I think that this kind of portfolio puts up better risk/return numbers over the next 5-10 years than a lot of other portfolios.

Another thing that’s cheap right now is insurance.  The VIX is back down under 18.  Any time the market is euphoric, complacent, or bored, is when you go shopping for insurance.  If you still have a hard time embracing the bullish technicals, setting up a long-biased portfolio may be easier if you have some hedges in place.

Don’t worry, a 10-15% correction is lurking at some point later in this year.  I just have no idea when.  If you have some hedges in place or a good exit strategy, that correction will be easier to live through.  Plus, you’ll probably have dry powder to take advantage of some riskier assets that are finally trading at a relative discount (if that’s your style).

Behind the scenes in real estate

In the last year, real estate has shown some more definitive signs of life.  Activity is finally picking up again.  Slowly.  But it’s picking up.  Alongside this, homebuilder stocks have rallied sharply since the end of last year.  Toll Brothers, Lennar, KB Home, DR Horton, and Pulte are all up in excess of 40 or 50% since last November.

As you can imagine, this has coincided with a noticeable pickup in housing starts.  But you can see just how far that has to go before normalizing.

This might be one of the most important economic charts that you can watch.  So many things are dependent on it.  The closer that new housing starts get to 1.2 million per year, the closer we’ll be to a healthy real estate market.  On top of that, normal housing construction means a meaningfully lower unemployment rate.  Every one housing start translates into about three or four new jobs, so the inevitable recovery in new home construction will naturally bring that unemployment rate down closer to historically normal levels.

This will also get U.S. GDP back up to a place where it won’t require epic stimulus to keep afloat.  When you add up the economic impact of building 1.2 million homes per year — the materials, the jobs, the multiplier effects on regional economies — the result is significant.  And it’s not like that’s an unreasonable target, either.  New household formation has in the past averaged around 1.3 million per year.  That’s an equally sensible rate to strive for because because the U.S. population grew by 2.1 million people last year and will continue to grow at a similar rate for the next several decades.

Every analyst in the business has their own forecast, set of metrics, or policy prescription for how to “fix” the economy.  For me, it’s pretty simple.  Show me a U.S. that’s building 1.2 new homes per year and I’ll show you an economy that is healthy and normal.

That’s my personal “all clear” signal.  New home starts.  The quicker we get there, the sooner everyone can feel good about the U.S. economy again.  I’m in support of basically any policy that speeds that outcome up.

But right now, a few things are getting in the way of that.  Some of these are obvious, others less so.

We have to start by looking at current inventory.

Inventory drying up.  Or is it?

In the last year, existing home inventory has fallen substantially.  In fact, I would say that existing inventory has collapsed.

What the heck going on?

At first glance it would appear that inventory is back in line with or even below historical norms.  That would be a really, really good thing but I’d caution you not to get too excited about this trend.  That existing home inventory chart underestimates several things.

First, sellers, particularly those who don’t need to sell, are taking their homes off the market and waiting for conditions to improve.  They’ve been doing this for a while, but they’ve really been doing this in the last year.  Then there are seasonal factors; the winter season normally features lower inventories.  On top of that, nationwide foreclosure volume has also decreased quite a bit in the last year as banks and regulators try and sort out the “robo signing” mess and the legal technicalities of the foreclosure process.

The result is a much lower current existing inventory.  But then we have the shadow inventory.  Those are properties that aren’t technically on the market, but probably would be if it was a more normal environment.

One of the side effects of slowing down the foreclosure process is that it has also slowed down the conversion of the shadow inventory to official inventory.  Depending on who you talk to and how you measure it, the shadow inventory is at least 2.1 million units.  That’s the number of mortgages that are currently in foreclosure but haven’t hit the market yet to be re-sold.  If you add in the number of mortgages that are seriously delinquent and will most likely end up in foreclosure at some point, that shadow inventory swells to around 4 million units.  Shadow inventory is even bigger if you count everybody that is 30-days past due, but I’m reluctant to add those folks when I want to do a more realistic inventory analysis.

That’s a total inventory — existing + shadow — of over 6 million units.  That’s definitely better than it was a couple years ago but you can see that we’ve still got a ways to go.  Existing homes sales are running at around 4.5 million per year, so hold your breath until around 2014 before getting really excited.

Look, we will not have a healthy real estate market until we work through this shadow inventory.  Pure and simple.  We can enact all the policy stimulus we want and keep mortgage rates low and create all sorts of fancy programs to incentivize real estate.  But the bottom line is that prices will not start trending back upward until supply and demand normalize.

It is no more complicated than that.

Judicial vs. Non-Judicial states

There’s another interesting trend that’s developing around the country, and it’s the legal differences that some states have with others.  Some states require a judge and a court to oversee the foreclosure process and some don’t.

According to Lender Processing Services (LPS), loans stay delinquent about 40% longer in judicial states than they do in non-judicial states.  This should hardly surprise you.  Get the courts involved in anything and the process takes much longer, though the final outcome is always the same.

It  might sound like an esoteric bit of legal trivia, but this is a very important consideration when it comes to fixing the major problem with the housing market.  There is still way too much inventory in the market and even a freshman Econ student can tell you that in order to stabilize prices, supply and demand have to clear.

I’ve heard a lot of chatter on Bloomberg lately about an interesting, anecdotal analysis of two similar counties in the Washington D.C. suburban area.  One county is in Maryland, a judicial state, the other in Virginia, a non-judicial state.  Demographics are fairly similar in both counties — both are made up primarily of higher-paying government and contractor jobs.  Their populations are  roughly the same size too, as are median home prices.  But since 2009, the Virginia county has recovered quicker and more dramatically.  Prices went up in Virginia last year while they went down in the similar county in Maryland.

Obviously, there are a lot of factors that differentiate one state from another.  But it’s interesting to look at how two fundamentally similar and adjacent neighborhoods have fared.  One has been able to work through its inventory of homes quickly while the other has been forced to take its time while the courts do their thing.  At some point both of these markets will converge and normalize, but in the meantime, there appears to be a slight divergence.

With another 2-3 million homes expected to go into foreclosure in the next couple of years, the way we handle foreclosures warrants careful thought.

Know your locale

My home state of Nevada is a non-judicial state.  For the most part the foreclosure process here has been pretty speedy in the post-bubble years.  Prices fell dramatically here in Nevada and they did so quickly.  Our quick foreclosure process isn’t the sole reason for that, but it undoubtedly helped cycle inventory along as rapidly as possible.  Up until last fall, the local inventory was populated with oodles of foreclosed properties.  In fact, Nevada had the highest foreclosure rate in the nation!  6% of the houses here got a foreclosure notice in 2011, which is rather striking when you consider that the national average is around 1.5%.

For dispassionate, objective market observers, this was probably a good thing.  Many buyers loved foreclosure properties because the prices represented a tremendous discount.  Realtors loved them because the closing process was lightning-quick, especially relative to short sales.  Sellers of non-distressed properties hated them, of course, because price-obsessed buyers weren’t willing to pay normal market prices.

In Nevada, distressed properties became the norm, with a small majority of total transactions classified as distressed sales (short sale or foreclosure).  And this was a good thing because we had a crazy amount of distressed properties to clear through.

But last October, a new law in Nevada went into effect requiring that banks produce all the original paperwork and document legal proof of their ability to foreclose.  As you can imagine, the effect here was dramatic.  After averaging 506 default notices per month from January to September, only 13 notices were filed last October.  That’s a 97 percent decrease.

I get it.  Property rights are touchy, important things.  I see the value in a robust set of rules and laws about who can do what to whom.  But after a reflection on the post-collapse years, it’s clear we need to weigh the benefits of that with the benefits of a fully-healed real estate market.  That’s a complicated question to answer.  I’m not sure I can do it.

In any case, this is an important thing to monitor as we monitor healing of the real estate market.  Ultimately, these distressed properties have to get turned over with new buyers owning them at normal prices and with normal mortgages.  The sooner that happens, the sooner we’ll have a healthy market.  Anything — anything – that slows that process down will delay that moment of final healing.

In case you still require final convincing that the courts really slow this process down, check out the striking difference between judicial states and non-judicial states:

On balance, judicial states have way more mortgages in the foreclosure process.  Non-judicial states get them through the system and ultimately re-sold much quicker.

That’ll do it for today.  I still have a few more things to discuss about real estate, as well as the most important single data point that every single person needs to know before making a decision to buy or sell their home.

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• There are always values to be found when shopping for individual stocks.  When doing that, see if you can find companies that 1) have a dividend yield greater than the 10year Treasury, 2) have a cleaner balance sheet than the U.S., and 3) are likely to grow at a rater greater than GDP over the next decade.
• New Home Starts is my personal economic “all clear” signal.  Show me a U.S. that’s building 1.2 million homes per year, and I’ll show you a normal economy.
• One of the biggest problems with the real estate market that still hasn’t really been dealt with yet is that supply and demand are grossly out of whack.  You have to read a little deeper into the data than simple existing home inventory to get a true reading on supply.
• The judicial system is really slowing down the foreclosure process and clearing out the supply backlog.  Different states have different policies, but no surprise, the ones that get the courts heavily involved are the ones that take longer to put a distressed property back in the hands of a strong buyer.