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What Supply Says About The Real Estate Market

by D.R. Barton, Jr.

"Strangely enough, this is the past that somebody in the future is longing to go back to."—Ashleigh Brilliant, American cartoonist

Different sports have their own measuring sticks that outsiders use to assess the participants’ capabilities. People want to know if a baseball player can throw a 90-mph fastball. Golfers are “muy macho” if they can hit a 300-yard drive. And basketball players are always asked if they can dunk (for those not familiar with basketball, a "dunk" is when a player is able to jump high enough to slam the ball through the hoop before it leaves his or her hand).

The summer before I went off to college at age 18, I was very close to being able to dunk a basketball. I could dunk a volleyball, which is smaller, but not a basketball. My problem was a combination of hand size and leaping ability. Players with hands large enough to palm the ball (or hold it firmly with one hand) don’t have to jump as high to dunk it as guys with smaller hands. I’m only about 6 feet tall, and while I have big feet, somehow I got stuck with small hands.

Then, in one instant, my dunking dreams died altogether. During a pick-up game at the gym, I glided toward the hoop to take a shot and landed directly on a defender’s foot. My left ankle rolled over, I heard the classic "pop" of ligament separating from bone, and my carefree summer was over. Four weeks in a cast and six weeks of rehab later, I was walking and running just fine, but I couldn’t jump as high as before. In fact, I’d lost about four inches from my vertical leap, and thanks to the structural change in my ankle, I wasn’t going to get those inches back.

Since I wasn’t going to play basketball in college, I had a decision to make: I could continue to long for the days when I could almost dunk, or I could work on the strong points of my game—shooting and ball handling. Realizing that I was not going to get those 4 inches of leaping ability back, I chose to work on my shooting. I can still shoot a basketball quite well to this day.

Let’s say, for the sake of analogy, that price is the real estate market equivalent to leaping ability. From 2006 to 2009, the real estate market basically tore ligaments in both of its ankles. In the process, it lost a lot more than 4 inches from its vertical jump—and it’s not getting those inches back anytime soon. My research leads me to believe that we won’t see the real estate markets at even pre-bubble levels for another generation. Building on last week’s article, let’s look at some additional data on why the rebound will take so long, and also explore what could render this analysis moot.

Available Inventory Showing Signs of Recovery

In last week’s article, we looked at some demand-side issues that could hinder the depth and duration of a real estate market rebound. Today, let’s dig a bit deeper into the supply side of the equation.

We’ll start with the "official" numbers. The National Association of Realtors reports a monthly accounting of existing home sales and inventory. July’s report of June data showed that sales had dropped 5% from the previous month. The first-time buyers figure also dropped in June to only 32% of total sales. During "normal" pre-bubble times, first-time buyers accounted for around 45% of all home sales.

This data leads analysts to two conclusions: one is that speculators are buying more than the "normal" share of houses and that the supply of affordable housing is growing tighter. One might assume from this data that the unsold housing inventory in general is also dropping quickly, but digging just a bit reveals that this isn’t the case.

Some markets are finally showing signs of life, and speculators have started stepping in. Bargain-hungry flippers have been snapping up properties that are "on the market" in many previously hot areas like Las Vegas. While the unsold inventory is dropping, it is doing so very gradually and is only part of the story. The following graph from a previous article (read the article here) is so important and useful to our analysis that I’m showing it again:

This chart from Lance Roberts shows that vacant houses are being held off the market in record numbers. The reasons vary, but regardless, the chart reveals that recent modest sales upturns affect a tiny fraction of all the vacant homes—the proverbial tip of the iceberg.

Shadow Inventory Levels: A Long-Term Drag on the Market

Let’s start with a simple definition: shadow inventory represents houses that are not formally listed for sale but are distressed in some way and will soon come to market. Since the term was coined a few short years ago, pundits have kicked it around while others (most of whom have a financial interest in a real estate market rebound) try to downplay the whole idea.

How many houses are we talking about? The National Association of Realtors currently lists about 2.4 million homes for sale, or about 6.6 months of inventory. Those who have tried to track the shadow inventory have come up with widely varying figures (because there is no "standard" for what to include). Current figures range from 1.5 million units on the low side to 15+ million on the high side. For those who think the high side number is bogus, consider this chilling fact: the market data firm CoreLogic reports that the portion of all mortgaged homes under foreclosure in Florida is a staggering 11.5%. That’s many times above the national average (which is still high at 3.4%), but it points to the size of the hole we’re still in—many millions of houses. Here’s another number that validates the mid-to-high-end estimates: there are around 6 million homes that are somewhere between "delinquent on payment" and "in foreclosure." The problem of "too much inventory" is far from solved.

Some Thoughts from the Front Lines

I exchanged some thoughts with Van this week about real estate, and he shared some observations based on his residential real estate experiences over the past few years. Van said that recent buyers of single-family homes fell into three general categories:

• Those who were buying in a declining market (speculating)
• Those who were buying a house with 3% down, often using retirement money for the down payment
• Those who were buying because the government was paying them up to $8,000 in tax rebates to do so (they could put $3,000 down on a $100,000 home and get $8,000 back in tax credits)

From what Van has seen, many current home buyers won’t be able to sell their house if prices decline again because they simply won’t be able to afford paying the closing costs. Van’s experiences don’t inspire much confidence about any real follow-through on the recent upturns in this market.

A Game Changer?

Is there anything that might change the housing market scenario? Yes, a structural change in the residential real estate market. What could a game-altering structural change look like? A regulatory/policy shift, pure and simple.

If the policy wonks become worried at some point about the housing market dragging the larger economy down, they could pull out some very big guns. What would happen if the government offered massive tax breaks for new mortgages, or offered government-backed mortgage forgiveness for everyone who had a negative balance on their note? Housing prices would certainly start marching up again. Actually, it would not surprise me to see such a "short-term gain, ignoring long-term pain" program enacted down the road.

The Bottom Line

Houses may indeed be moving faster now than last month or last year, but in many respects, this "housing market recovery" is an illusion. Every reasonable analyst would agree that all the various housing stop-gap programs and injections of money into the financial system have never even gotten the market close to a clearing price for residential properties (a market clearing price is when buyers and sellers agree on a fair price, or when trades are made that “clear” the market).

With the market still out of balance, savvy speculators and investors who play the game well will continue to find opportunities in certain markets. But my research leads me to conclude that the days when every cashier and waitress was "in real estate" will not return for some time. When the young Millennials (also known as Generation Y), who outnumber Gen-Xers by 10–20 million, enter prime home-buying age, we’ll finally see real demand in the housing market again. That should start to happen in 13 to 18 years. Until then, look for a cycle of gradual moves up and chops (drops) in the real estate market, unless there’s a structural change in the market.

If you’ve found this article useful or thought-provoking (or both), I’d love to hear your thoughts and feedback. Just send an email to drbarton "at" vantharp.com.

Great Trading, D. R.

About the Author: A passion for the systematic approach to the markets and a lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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Trading Tip

Five Ways to Make Money in a Trading Business

by Van K. Tharp, Ph.D.

There are several methods for growing your trading business, especially when capital isn’t a problem. At first glance, they might seem obvious, but I’ve found that most people still don’t think about them enough, let alone implement them. Here are five key ways to grow your trading business:

1. Develop new, improved trading systems. Each system can help you make more profits, especially if it isn’t correlated with the other systems. Continue to look for new systems that can become new profit centers for your trading research. Some of your systems may stop working in certain market conditions, so it’s always good to have more systems in the pipeline.

2. Find more markets in which to apply each system. Let’s say you develop a great system that works on the S&P 500 index. It gives you five trades a month and has an expectancy of 2R. This means that, on average, it can probably generate 10R each month. But what if the system also works on other major stock market indices with the same results? If you can add 10 more indices, you might be able to make 100R each month.

3. Add traders. Each trader can handle only so much work and so many markets effectively. Let’s say that a good trader can trade $50 million effectively. When the total goes above that level, however, the trader’s effectiveness seems to drop off. On the other hand, ten good traders may be able to handle $500 million effectively.

4. Make your traders more effective at what they’re doing. Let’s say a trading system generates an average return of 40% each year. You can measure the effectiveness of a trader by the number of mistakes he or she makes. For example, a typical trader may make 20% worth of mistakes each year on a 40% system. That kind of trader, at 80% effectiveness, would allow you to generate 32% from the system. But what if you could make the trader more effective? What would happen if you gave your traders effective coaching that could reduce their mistakes to 5% each year? That amounts to a 75% increase in effectiveness per trader per system per year. You can expand a trading business immensely through coaching that allows your traders to become more effective.

5. Optimize your position sizing strategies for your objectives. To do that, you must take each of the following steps:

• Clearly determine what the objectives are for your business. Many people and many firms do not do this well, if at all.
• Determine the R-multiple distribution generated by each of the systems you use.
• Simulate different position sizing algorithms to determine which of the thousands of possible algorithms will meet your objectives most effectively.
• Apply that algorithm to your systems.

For example, suppose you want to make 200% on capital allocated to a particular system. You have a system that generates an average of 70R each year. If you risk 1% of your allocated capital per trade, you may find that you can make 70% per year from the system. However, if you increase the position sizing risk to 3%, you may find that you can make the 200%. Of course, increasing the position sizing risk will increase the potential drawdowns. You need to be fully aware of the downside to such changes.

All these factors can be multiplicative. For example, suppose you have three traders, each trading two systems in three markets. Each system makes about 60R per year per market, but the traders are only 75% effective in trading them. This means that they make about 15R in mistakes per system per market per year.

Let’s look at what this generates for the company. If you multiply three traders times two systems times three markets times 45R, you’ll find that the company generates 810R each year. Let’s look at the various changes we could make and see what kind of effect they might have.

• What if we added three more traders? We might be able to double the total return to 1,620R.
• What if we added three more markets for each system? We might now increase the returns to 3,240R.
• What if we added one more system per trader? We might now increase the return to 4,860R.
• What would happen if you increased the efficiency of your traders to 90% (which we might have to do for them to handle the extra work)? We’d get an additional 20% profit, which would raise us to 5,832R.
• What if we made our position sizing method more effective and increased our profits another 50%?

Of course, no trading business would be able to do all the things I’ve suggested at the same time, but what if you could do a few of them? What would be the impact on your bottom line? If you’re considering some of these changes, concentrate on trader efficiency and on more effective position sizing methods to meet your objectives.

*This article was excerpted from Van's book Super Trader.*

About the Author: Trading coach and author Van K. Tharp, Ph.D. is widely recognized for his best-selling books and outstanding Peak Performance Home Study program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.vantharp.com.

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