q, the markets moved mostly in tandem from the middle of 2002 tothe middle of 2003. They both started moving up in March 2003 and rosetogether through that June. At least part of the rise in REITs can be attributedto the sharp drop in the Treasury note yield that took place in May of thatyear. (This sudden drop in long-term rates was precipitated by the Fed’s
15.0%
Dow Jones REIT Index10-Year T-Note YieldNasdaq Composite
10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%-30.0%-35.0%-40.0%© StockCharts.com 2003
F
M
FIGURE 14.4
A
M
J
J
A
S
O
N
A comparison of the three markets.
D
F
M
A
M
J
-45.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 222
222
INTERMARKET ANALYSIS
May 6 announcement that it was concerned about the threat of deflation.)Most of the interest rate decline was seen in long-term rates (especially in the10-year note), which are the rates that have the most impact on real estateand housing. It could be argued that the jump in REITs during the spring of2003 had less to do with a rising stock market and more to do with the plungein long-term interest rates.
REITS UNDERPERFORM AFTER SUMMER OF 2002The REIT rally that started in the spring of 2003 carried prices back to thehighs of the previous spring. This suggested that the REIT rally that startedduring the spring of 2003 had reached a critical point in its three-year uptrend.Any test of a previous high is regarded as a test of an existing uptrend. Mosttopping patterns usually start with an inability to exceed a previous peak. Figure 14.5 plots the Dow Jones REIT Index from the start of 2002 to the middleof 2003; it shows the rally that started during March 2003. It also shows theREIT Index reaching a crucial chart juncture as it retests the highs formedthe previous year. REITs were also starting to underperform the rest of the
FIGURE 14.5
REITs are challenging overhead resistance.
14_chap_murphy.qxd 10/31/03 12:21 PM Page 223
Diversifying with Real Estate
223
market by the middle of 2003, another warning sign that investor interest inthe group was weakening.1In sector work, relative performance is almost as important as absoluteperformance. The line plotted along the bottom of Figure 14.5 is a ratio of theDow Jones REIT Index divided by the S&P 500 through June 2003. The ratioline started dropping the previous October (just as the stock market wasstarting to bottom). The ratio line shows a negative slope since that peak. TheREIT runup that started in March 2003 was also accompanied by a fallingratio line. This meant that even though the REITs were rising, they were rising more slowly than the S&P 500. It is normally a sign that a market sector haslost its leadership role and is falling out of favor. If that trend continued, itraised two possibilities. One is that the stock market has bottomed, whichreduces the need for the defensive qualities of REITs. Another possibilitymight be that the relative weakness in REITs is an early sign that long-termrates are starting to scrape bottom. Since falling rates have been the drivingforce in the real estate and housing boom, any hint of higher rates (and astronger stock market) could prove to be a double negative for REITs andhomebuilding stocks.
HOUSING IS INTEREST RATE-SENSITIVEReal estate and housing are tied very closely to the direction of interest rates.This explains why housing has generally been considered to be countercyclical; it moves in the opposite direction of the normal business cycle.Homebuilding activity tends to be strongest when interest rates are falling,which generally happens in a weaker economy. Conversely, a strong economy usually coincides with rising interest rates, which has a dampening effecton the homebuilding industry. Tighter monetary policy in a strong economyhas historically had a retraining effect on real estate loans, which tend toweaken even as the economy strengthens. New home sales have in the pastalso displayed similar countercyclical behavior by turning down during economic expansions (when rates are rising) and bottoming during recessions(when rates are falling). This is primarily due to housing’s inverse correlationwith long-term interest rates. Housing starts (which measure the number ofhousing units beginning construction each month) also have a history offalling during economic booms and recovering strongly during economicbusts. Again, the determining factor seems to be the direction of long-termrates. However, this has not always been the case.1
At the start of October 2003 the DJ REIT Index finally exceeded its 2002 peak.
14_chap_murphy.qxd 10/31/03 12:21 PM Page 224
224
INTERMARKET ANALYSIS
REAL ESTATE DOES NOT ALWAYS FOLLOW INFLATIONReal estate has historically been called an inflation hedge as well as interestrate-sensitive. It has also been said that real estate prices fall when the stockmarket falls. All of these statements have been made about real estate. Andall of them are true—but not always. Home prices and real estate valuesplunged during the deflationary years of the Great Depression. Home pricesfell between 1925 and 1935 and did not start rising until the late 1940s. Landvalues, especially those in the Midwest, also plunged during the 1930s asfarm commodity prices collapsed; they started rising again with the rate ofinflation during the 1940s and 1950s. This seems to support the view thathousing and real estate are inflation- and deflation-sensitive. Home valuesalso soared during the inflationary 1970s and peaked along with inflation inthe early 1980s. The value of farmland plunged after 1981 when agriculturalcommodity prices peaked. This, too, supports the link with inflation. How,then, do we explain the surge in real estate and home values over the pastfive years when inflation has been virtually nonexistent and deflation hasbeen the main threat? This is exactly the opposite of what happened duringthe 1930s. The dramatic increase in real estate values and homebuilding overthe past five years cannot be linked to inflation.
REAL ESTATE DOES NOT ALWAYS FOLLOW INTEREST RATESReal estate’s link to interest rates has not always held up. The collapse in realestate and housing during the 1930s coincided with falling long-term rates.The real estate boom of the 1970s took place while long-term rates wererising. In the latter case, the beneficial impact of an inflationary spiral duringthe 1970s appears to have overcome the harmful effects of rising interestrates. In the 1980s, housing and real estate values weakened as interest ratesdropped. During the 1930s, the 1970s, and the 1980s, the link to inflationappears to have been much greater than the link to interest rates.
REAL ESTATE DOES NOT ALWAYS FOLLOW STOCKSHow about the real estate’s link to stocks? Stocks fell along with home andland values during the 1930s and turned up with them during the 1940s.Stocks and real estate values rose together until the late 1960s. During the1970s, however, real estate soared while stocks endured a decade-long secular bear market. Real estate and housing weakened during the early 1980s
14_chap_murphy.qxd 10/31/03 12:21 PM Page 225
Diversifying with Real Estate
225
just as the stock market was starting the biggest bull market in history. Since2000, real estate and housing has prospered as the stock market endured itsworst beating in 70 years. Recent experience contradicts the notion that realestate follows the stock market.It seems, then, that none of the historical reasons that are normally citedto explain real estate activity—inflation, interest rates, stock prices, and thebusiness cycle—adequately explains the ebbs and flows of real estate andhomebuilding. The answer to the puzzle must lie elsewhere. The answerappears to be that real estate moves according to a different cycle than all ofthe other financial markets and the economy.
THE LONG CYCLE IN REAL ESTATE ACTIVITYIn his 1987 book entitled The Wall Street Waltz (Contemporary Books, Inc.),Kenneth Fisher (CEO, Fisher Investments, Woodside, CA) describes an 18year cycle in real estate activity discovered in 1940 by Clarence Long (whichis why it is called the Long Cycle). Mr. Fisher blends the 18-year real estatecycle with the 55-year Kondratieff Wave and the four-year business cycle(which is also called the Kitchin Cycle after its inventor Joseph Kitchin).(Both of these cycles are discussed in Chapter 12.)
COMPARISON TO OTHER CYCLESLong tracked the real estate cycle from 1870 to 1940. Since its length is 18years (from peak to peak or trough to trough), approximately three LongCycles take place in one Kondratieff Wave. This also means that one 18-yearreal estate cycle includes at least four business cycles (which average fouryears apiece). Fisher points out that business cycles tend to be strongestwhen the Kondratieff and Long Cycles are in upswings; they tend to be weakest when both longer waves are in downswings. This accounts for some similarities between present-day conditions and those of the 1930s—and somedifferences.
SIMILARITIES AND DIFFERENCES:PRESENT DAY AND THE 1930sThe 55-year Kondratieff Wave and Long’s 18-year real estate cycle both turneddown in the late 1920s. As a result of this downward convergence in two
14_chap_murphy.qxd 10/31/03 12:21 PM Page 226
226
INTERMARKET ANALYSIS
major economic cycles, stock values collapsed along with home and land values. The deflationary impact also crushed commodity prices and pushed interest rates sharply lower. This differs from the current situation in that only oneof these two major economic cycles turned down. Chapter 12 suggested thatthe Kondratieff Wave ended its plateau period in 1998 and ushered in the current deflationary cycle. The Long Cycle, however, kept rising. Because homebuilding is so important for economic activity, the fact that real estate keptrising during this economic cycle appears to have cushioned the downturn inthe economy since 2000. A critical issue now is how long that real estate cyclecontinues. The best way to gain insight on this is by studying its history.
HISTORY OF REAL ESTATE CYCLE SINCE 1940Fisher puts a cycle top in real estate activity in 1945, 18 years after its 1927peak. Counting forward from the 1945 peak, he puts the next two peaks in1963 and 1981. He observes that real estate “stumbled badly” starting in 1963and that farm real estate values collapsed in 1981. (From 1981–1985, farmland in the Midwest lost over 40 percent of its value.) Counting forward froma 1954 trough, he puts the next real estate trough in 1972—just in time for theinflationary surge of the 1970s. Fisher puts the next scheduled real estatecycle trough sometime in the 1990–1992 time frame, which would explain therelative strength in real estate over the past decade. If Fisher’s timing of the18-year cycle is correct, however, it would mean that a peak in real estateactivity is overdue. The reason for the current real estate cycle stretching outlonger than usual is most likely an unprecedented drop in long-term interestrates to their lowest levels in a half-century. This means that the continuation of the current housing boom may be heavily dependent on interest ratesstaying low.
ARE HOMEBUILDING STOCKS LINKEDTO STOCKS OR RATES?There are times when homebuilding stocks are in sync with the stock market—and there are times when they are not. This may have more to do withbonds than stocks, however. Homebuilding stocks experienced bear markets in 1990 and 1994 right along with the rest of the stock market. In bothinstances, however, bond prices fell along with stocks, pushing long-termrates higher. It could be said, then, that homebuilders were reacting to higherrates. It is difficult to say whether the homebuilders were being influenced by
14_chap_murphy.qxd 10/31/03 12:21 PM Page 227
227
Diversifying with Real Estate
the fall in the stock market or the rise in long-term rates. In the two prior bearmarkets, the correct answer seems to be that homebuilders were being influenced by both markets. An examination of the 1994 bear market in stocksillustrates this point.Figure 14.6 shows the price of Centex (a homebuilder) at the bottom ofthe chart, the yield on the 10-year Treasury-note at the top left, and the S&P500 in the middle left. During that bear market year, Centex fell (as did otherhomebuilders). In fact, homebuilders did a lot worse than the general marketthat year. After participating in the stock market downturn, Centex turned upwith the S&P 500 near the end of that year. It can be said, then, that Centex(and the other homebuilders) were moving with the stock market. A closerinspection of Figure 14.6, however, suggests that the movement in the homebuilder was more closely correlated with the yield on the 10-year T-note,which turned up at the start of the year and peaked during the fourth quarter.Rising rates and falling stocks hurt the homebuilders in 1994; falling ratesand rising stocks helped them in 1995. Since bonds and stocks were in syncat the time, it did not really matter which one the homebuilders were following. Bond and stock prices were trending in the same direction. So were thehomebuilders. The positive link to stocks continued until the start of 1999when the S&P 500 and Centex started to trend in opposite directions.
50.0%
S&P 500 Large Cap Index10-Year T-Note YieldCentex Corp.
40.0%30.0%20.0%10.0%0.0%-10.0%-20.0%-30.0%-40.0%-50.0%© StockCharts.com 2003
F M A M J
FIGURE 14.6
J A
S O N D
F M A M
A comparison of the three markets.
J
J A
S O N D
F
-60.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 228
228
INTERMARKET ANALYSIS
HOMEBUILDERS DECOUPLE FROM MARKET DURING 1999Figure 14.7 shows Centex and the S&P 500 moving in lockstep from 1994through the end of 1998. From that point on, the homebuilder and the rest ofthe stock market started trending in opposite directions. In 1999, Centex(and other homebuilders) fell sharply while the S&P 500 rallied. A more dramatic example of the decoupling of homebuilders from the rest of the stockmarket, however, came in 2000. Figure 14.7 shows the major top in the S&P500 coinciding that year with a major upturn in Centex. Over the followingthree years, homebuilders continued rising while the stock market experienced its worst drop in generations.The positive link between homebuilders and the stock market had beenbroken. Clearly, the homebuilders (and real estate stocks in general) hadstarted to follow something other than stocks. This “something” was thedirection of long-term interest rates. During the prior decade, homebuildershad been moving with both bonds and stocks during bull and bear marketcycles. This was only because bonds and stocks were moving in the samedirection, though. When bonds and stocks started decoupling during the
250.0%
S&P 500 Large Cap IndexCentex Corp.
225.0%200.0%175.0%150.0%125.0%100.0%75.0%50.0%25.0%0.0%-25.0%-50.0%© StockCharts.com 2003
1995
FIGURE 14.7
1996
1997
1998
The two trends decoupled after 1998.
1999
2000
2001
-75.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 229
229
Diversifying with Real Estate
second half of 1998, the homebuilders revealed which one they were reallyfollowing—and it was not stocks.
HOUSING STOCKS LINK TO INTEREST RATESFigure 14.8 compares the yield on the 10-year Treasury-note to Centex fromthe start of 1994 to 2000. The inverse link can be seen very clearly. In fact,they are almost mirror images of each other. The two main turning points onthe chart came at the end of 1994 and at the start of 1999. The peak in longterm rates at the end of 1994 coincided with a major upturn in Centex. Forthe next four years, homebuilders rose while long-term rates fell. The troughin long-term rates at the start of 1999, however, coincided with a peak in thehomebuilders. It was right at this point that homebuilders decoupled fromstocks. (Bonds and stocks had decoupled during the second half of 1998.) Itbecame clear at the time that homebuilders were more closely tied to bondsthan they were to stocks. Bonds and stocks were traveling in opposite directions. The homebuilders had to follow one group. They followed bonds.
120.0%
10-Year T-Note YieldCentex Corp.
100.0%80.0%60.0%40.0%20.0%0.0%-20.0%-40.0%© StockCharts.com 2003
A J
O
FIGURE 14.8
A J
O
A J
O
A
J
O
A
J
Centex has moved inversely to rates since 1994.
O
A J
O
A
-60.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 230
230
INTERMARKET ANALYSIS
MARKET ROTATION DURING 2000Figure 14.9 shows the dramatic market turns in long-term rates and Centex in2000. The year before, the drop in Centex had coincided with rising rates.(1999 was the year that crude oil and other commodities surged higher,which prompted the Fed to start raising short-term interest rates in the summer.) Long-term rates peaked in the first quarter of 2000—along with thestock market. This was caused by a massive rotation out of stocks and intobonds. The rise in bond prices coincided with a drop in yields. Centex (andthe other homebuilders) bottomed as rates were peaking. Once again, homebuilders had shown that they were being influenced more by the direction oflong-term interest rates than by the direction of stocks. In so doing, homebuilding stocks fulfilled their historical role as a countercyclical asset class.The drop in the stock market and interest rates signaled a significantweakening in the economy later that year. The housing industry was movingcounter to the stock market, the direction of interest rates, and the businesscycle. This is what a countercyclical asset is supposed to do. It is a goodthing, too. Throughout the three-year bear market in stocks, accompanied byan historic drop in interest rates, strength in the housing sector was about the50.0%
10-Year T-Note YieldCentex Corp.
40.0%30.0%20.0%10.0%0.0%-10.0%-20.0%-30.0%-40.0%© StockCharts.com 2003
D
F M A M J
FIGURE 14.9
J A S O N D
F M A M J
Centex bottomed as rates peaked in 2000.
J A S O N D
F
-50.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 231
231
Diversifying with Real Estate
only bright spot in an otherwise dismal economic landscape. There seems little doubt that the strong housing sector kept a bad economic situation fromgetting even worse. As rates plummeted over the next three years, a recordlevel of mortgage refinancing provided consumers with extra money, whichthey spent primarily on autos, home appliances, and home improvements.The rise in home values largely offset losses in the stock market. From anasset allocation standpoint, the rise in housing during the years after 2000was an example of the axiom that when one asset is going down, there isusually another one going up.
HOMEBUILDERS AND STOCKS RE-LINKAlthough homebuilders continued to do better than the stock market (on arelative basis) in the three years after 2000, they started to track the stockmarket more closely starting in the middle of 2001. Figure 14.10 comparesCentex and the S&P 500 from the middle of 2001 to the autumn of 2002. Centex bottomed with the market after the September 11 tragedy and weakenedwith the market the following spring. Although homebuilders still did better30.0%
S&P 500 Large Cap IndexCentex Corp.
25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%-30.0%-35.0%© StockCharts.com 2003
Aug
Sep Oct
FIGURE 14.10
Nov Dec
Feb Mar Apr
Trending together during 2002.
May
Jun
Jul
Aug
Sep Oct
-40.0%
14_chap_murphy.qxd 10/31/03 12:21 PM Page 232
232
INTERMARKET ANALYSIS
than the overall market during that period, their peaks and troughs weremore closely correlated. Figure 14.10 also shows that homebuilders hitanother big bottom during October 2002, just as the S&P 500 was hitting bottom as well. Although they rose much more strongly than the rest of the market after that lowpoint, housing stocks seemed to benefit from the market’snewfound stability. From that October into the following spring, interestrates and stocks moved sideways. In the spring of 2003, two things happenedthat gave another big boost to housing stocks.
FED’S DEFLATION FIGHT BOOSTS HOUSING STOCKSIn the spring of 2003, the stock market started a rally off a March bottom.This March bottom represented a successful test of the lows hit the previousOctober. In chart terms, this successful retest increased the odds for a market bottom. Within two months, most of the major stock averages hadexceeded the highs formed during the second half of the prior year. This bullish breakout in stocks gave a boost to homebuilders. They got another bigboost from rates as well. On May 6, 2003, the Fed announced its intention tofight the threat of deflation. Shortly thereafter, long-term rates plunged. Mortgage rates fell to the lowest level in history. The combination of plungingrates and rising stocks caused an explosive move to record highs in homebuilding stocks.
THE HOUSING TRADEOFFBy the middle of 2003, the housing sector was still the strongest part of thestock market and the economy. It was feeding off a combination of lowerlong-term rates and a stronger stock market. The trade-off was that astronger stock market might be hinting at a stronger economy, which couldincrease the demand for housing. This would be good. The risk was that astronger economy might result in higher interest rates. This could be bad.The sustainability of the housing boom would probably depend on which ofthe two markets—bonds or stocks—housing followed. A strong economicrecovery could hurt bonds but would help stocks. A weak economic recoverymight not be bad for bonds but could hurt stocks. The worst-case scenariofor the housing and real estate sector would be a combination of rising ratesand a weak stock market.
14_chap_murphy.qxd 10/31/03 12:21 PM Page 233
Diversifying with Real Estate
233
JAPANESE REAL ESTATE COLLAPSEDTWO YEARS AFTER STOCKSThe Japanese stock market peaked in December 1989 and began a 13-yeardecline that eventually turned into a deflationary spiral. The Japanese realestate market peaked two years after the Japanese stock market. So far, thishas not been the case in the United States. However, the Fed’s battle againstdeflation generates some real risks for American real estate and the economy. Its attempt to reflate the U.S. economy has resulted in a weaker dollarand rising commodity prices. Both of these trends threaten to raise long-termU.S. interest rates, which are trading near historic lows. Rising long-term ratescould short-circuit a budding U.S. economic recovery. Even more dangerousis the possibility that rising rates could hurt a housing sector that has thrivedon plunging rates. Since housing and real estate are countercyclical, it is normal to expect some weakening in this sector as part of an economic recovery. The danger is that rising long-term rates could start to hurt the housingsector before the American economy is in full recovery. A jump in long-termrates starting in mid-June 2003 caused a sizable correction in homebuildingstocks that lasted throughout the third quarter. That may have been a warning that rising rates might not be good for the housing sector.
14_chap_murphy.qxd 10/31/03 12:21 PM Page 234
15_chap_murphy.qxd 10/31/03 12:24 PM Page 235
C H A P T E R 15
ThinkingGlobally
ALL MARKETS ARE RELATEDWhen I wrote my earlier book on intermarket technical analysis 13 years ago,my purpose was to demonstrate the simple reality that all markets arerelated. When I first made the claim in 1990, it seemed a little far-fetched. Inthe new millennium, however, many of the relationships that I describedin the earlier book are taken for granted. The link between bonds and stocksis analyzed daily in the financial press and on TV. Intermarket subjects likethe impact of a falling dollar on gold are routinely discussed on BloombergTV and CNBC. Economists debate the seriousness of the deflation threat andthe impact that it could have on the financial markets. I heard one international analyst talking on television the other day about global opportunitiesin the dollar bloc countries like Australia and Canada because of their higherinterest rates and strong currencies. Another analyst discussed the benefitsthat rising commodity prices could bring to emerging markets. This is prettysophisticated stuff. We have all come a long way since 1990 in our awarenessof how any market in the world has an impact on many others. Traders havealso learned how to profit from these impacts.The idea that all global markets are linked in some fashion seems obvioustoday. If you tune into Bloomberg radio early in the morning, you will getprice quotes on key commodities like gold and oil, foreign currencies, foreignbonds, and foreign stock markets. You can hear how American shares arebeing traded in overseas markets even before they start trading here. In mostinstances, these early morning quotes determine how the trading day willstart in the United States. We have learned to pay attention to overseas235
15_chap_murphy.qxd 10/31/03 12:24 PM Page 236
236
INTERMARKET ANALYSIS
trends. Instant communication has made the world seem much smaller andmuch more interdependent. Some American stock market analysts did notbother watching the overseas markets 10 years ago and did not care whatthey were doing. Japan could have been on another planet as far as theywere concerned. Not anymore. Japan’s economy has become a big topicthese days because of its deflationary problem, which threatens to becomeeveryone else’s problem. The Fed has been busily studying Japan veryclosely to see what it has tried in the battle against deflation.Computer terminals and the Internet enable traders to view global trendsand watch them trade off each other. Financial data on all global markets(including bonds, stocks, and currencies) are reported instantaneously onquote screens all over the world. A decision by a foreign central bank tolower interest rates (or not to lower them) may have an immediate impact onthe trend of the dollar, the stock market, and the gold market here in thestates. Much has changed in the financial markets over the past decade on aglobal scale and in our ability to monitor these changes.Years ago, traders were not very aware of linkages that existed betweenthe financial markets. Now, with quotes and charts so readily available,traders react much more quickly to changing market trends in Chicago, NewYork, or Hong Kong. Trading activity in the United States sets the tone fortrading overseas and vice versa. How overseas markets react to the American stock market close is an indication of whether or not a move in NewYork has staying power. If foreign markets follow the U.S. market higher,odds are much better for a higher opening the next day in the United States.If stocks weaken overnight, they will probably do the same thing in NewYork the next morning.
GLOBAL TRADE INCREASES IMPACT OF EXCHANGE RATESThe “Commodities Corner” page in the July 14, 2003 issue of Barron’s makesthe point that “the share of world commodities traded across borders hasrisen over time, accentuating the importance of exchange rages.” MatthewShane, a senior economist in macroeconomics at the U.S. Department ofAgriculture, is quoted as saying that domestic agricultural prices are becoming increasingly responsive to exchange rates. He calculates that as much as45 percent of the change in the value of American agricult