September 2012 Newsletter
Can Rising Housing Prices Be Bad for Investors?
The Consumer Price Index was released in mid-August for the month of July. On an annual basis, the CPI increased 1.4 percent and the Core CPI, which excludes food and energy prices, rose 2.1 percent.[i] This was the smallest 12-month gain for the CPI since November 2010. Yet, at the same time, housing statistics have turned positive over the past few months leading many economists to speculate that housing prices have already bottomed. In the latest reading of the Standard & Poor’s/Case-Shiller index of 20 large cities, housing prices rose 2.2 percent month-over month.[ii] This marked the largest monthly increase in over a decade. Good news? Certainly. Expected? Yes. As stated in an article that I wrote in April entitled Are We on the Brink of a Housing Recovery? , I wrote: From 1983 to 2000, the price-to-rent ratio fluctuated between 1.0 and 1.15. Then, from 2000 to 2006, the ratio shot up to 1.8 before crashing down to 1.2 in 2008. Currently, the ratio stands at around 1.1. This is approximately what the ratio was in the mid-to-late 1990s. This suggests that the ratio is approximately near its average level for the 1980s and 1990s.[iii] Therefore, the increase in demand over the past few months for houses has largely been a rational response by a consumer faced with two options with one of the two appearing significantly more attractive than even one year ago. While housing prices have declined, rental prices have increased. According to a study released in July by Trulia, an online real estate site, rental prices increased 5.4 percent over the past year nationwide.[iv] The Boston area has been no exception. As the following chart from a recent Boston Globe article demonstrates, average monthly rent prices in Boston increased by 7 percent in the past year to $1,881.[v]
How would rising housing prices and rental rates affect the CPI? This has been a constant debate by the Federal Reserve system over the years. In early 2012, the Cleveland Fed released a commentary on this very topic.[i] In their conclusion, they determined the following:
Owners' Equivalent Rent's Effect on the Core CPI Forecast (Percent Change Q4/Q4)
Statistic 2012 2013 2014
OER 2.5 3.2 3.5
Core CPI excluding OER* 1.5 1.5 1.5
Core CPI 2.0 2.2 2.2
Effect of OER on the Core CPI 0.5 0.7 0.7
*Assumed to grow at the current trend in underlying inflation.
Sources: Bureau of Labor Statistics; author’s calculations.
Owners’ Equivalent Rent (OER) is the amount a homeowner would pay to rent his or her home and thus is the proxy the Bureau of Labor Statistics uses for the housing portion of the CPI. According to the forecasts of the Cleveland Fed, the OER could cause the Core CPI to rise by at least 0.5 percent in each of the next three years. Why does this matter (besides the fact that you could either be paying more for rent or could finally see the value of your house rise)? The Federal Reserve has undertaken significant monetary infusions in order to attempt to jump start the economy. Because inflation has remained tame, the Fed has continued to engage in various programs (What number QE is the Fed currently contemplating?). If inflation were to pick up because of a rise in the OER, the Fed might have to think twice before opening up the monetary spigots again.
The Insecurities of Food Inflation
In the United States, the average consumer spends approximately 10-14 percent of his or her budget on food.[vii] In comparison to many individuals in the rest of the world, food is a relatively small portion of an American’s budget. Because of this fact, the average American has been relatively immune to the soaring prices of corn, wheat and soybeans. Prices for these commodities have been pushed up by more than 25 percent in the summer of 2012.[viii] Why are prices for these commodities increasing? Fundamentally, more people around the world are becoming more affluent. As people enter the middle class in China, Brazil, and in other countries, they tend to eat more meat. In order to produce more meat, more grains are fed to animals causing a lower supply. Yet, farmers have been aware of this dynamic for years. In response to higher prices for these commodities over the past few years, farmers have increased their acreage devoted to these crops. This year marked a record for crops planted.[ix] Despite their efforts, prices continued to shoot up. One reason has been the hot weather experienced across the globe. According to the National Oceanic and Atmospheric Administration, July was the hottest month on record in the continental United States and was the 329th consecutive month with a global temperature above the 20th century average.[x] Although the weather is unpredictable (the Weather Channel’s recent decision to implement a 30-day forecast has been met with skepticism), there is little doubt that 329 consecutive months is a long trend of warmer weather and is probably here to stay for at least the next couple of decades. To attempt to combat the warm weather, farmers have used new fertilizers to try to boost the quantity and quality of their crops. Has this been effective? As emphasized by asset manager Jeremy Grantham in his Q2 2012 quarterly report, grain productivity has declined decade by decade since 1970 from 3.5 percent to 1.5 percent.[xi] Grantham also spells out the consequences of these poor results:
For several poorer countries though, including Egypt, food costs have risen to 40% and above of their total expenditures following the surge in global grain prices since 2002. (Wheat is the critical source of calories in Egypt and the rest of North Africa and much of their wheat is imported so they are directly exposed to global price moves.) Global grain prices almost tripled in the last 10 years. If they were to double in the next 20 years it would be painful indeed even for rich countries, but simple arithmetic will show you how impossible the situation becomes for those poorer countries that start out with a 40% share of food in their budget.
Therefore, the real effects of higher food prices might not be felt only in the grocery store. Throughout the world – especially in various countries in Africa and Asia – uprisings might occur as individuals protest the rising prices. One solution is for governments to subsidize food in order to keep prices low for the residents of their country. Countries with surpluses, including China and many oil exporting nations, can afford to subsidize food to appease their citizens. This solution might not be available for the rest though.
Butter Production in Bangladesh
“Sell in May and Go Away” is an adage that is commonly stated in financial publications during the spring time. This saying stems from the belief that if an individual sold his positions in May and remained on the sidelines until October, he or she could beat the overall market. This did not hold in 2012 (at least not as of early September). However, according to studies anyone who sold the S&P 500 index stocks in May and bought back in October would have averaged an annual return of 8.4 percent over the past 86 years (versus a gain of 5.1 percent if you did the opposite). Over this time, an individual would have achieved annual returns of 10.0 percent though if he or she just held onto the index stocks for the entire year. Therefore, don’t go rushing to sell your stocks after seeing this chart: [xii]
There are various theories for this underperformance. One is that mutual funds sell underperformers before their fiscal years end in October in order to take advantage of capital losses. Another is that individuals begin to sell positions in order to receive their required minimum distributions. Some psychologists even suggest that people begin to feel negative as the days become shorter and this negative vibe is reflected in the performance of stocks. When hearing statistics and theories such as this, I think of one statement: past performance is not indicative of future results. Many quantitative investments firms search through data to attempt to discover patterns. Then, they sometimes use these patterns to try to trade profitably. The underlying question is whether the patterns are a result of actual fundamentals or are just coincidental. A study initially written in 1995 looked at correlations with the S&P 500 that could be discovered through data mining.[xiv]
During the ten year period (1983-93) that the authors studied, butter production in Bangladesh explained 75 percent of the variation of the S&P 500. Then, the authors added a second variable: United States cheese production and included U.S. butter production. These variables explained 95 percent of the variation in the S&P 500. Finally, the authors added the special ingredient: sheep population in Bangladesh and the U.S. Through these three variables, the authors were able to explain 99 percent of the movement of the S&P 500 over that time period. The conclusion from this study is simple, but important: if a person looks at enough data, chance associations are bound to appear. When evaluating stocks or the financial markets, studying annual reports and relative valuations is still the basic step that every investor should take. Therefore, the next time that you read statistics on the best and worst performing months for stocks or the effect of butter production in Bangladesh on the S&P 500, please keep in mind that this data might not hold in the future and might actually be rather meaningless.
*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. All investments involve the risk of potential investment losses and no strategy can assure a profit. Past performance is not indicative of future results.
[ii] Lazo, Alejandro. Home Prices Rise Sharply. 1 Aug 2012. Los Angeles Times. 20 Aug 2012. <http://articles.latimes.com/2012/aug/01/business/la-fi-home-prices-20120801.>
[iii] Crowe, David, Robert Denk, and Robert Dietz. Pent-Up Housing Demand. 2 Feb 2011. Housing Economics. 21 Mar 2012. <http://www.nahb.org/generic.aspx?genericContentID=152243&channelID=311.>
[iv] Swinney, Sarah. Rental Prices Increase Nationwide. 6 July 2012. NBC. 22 Aug 2012. <http://www.nbcdfw.com/the-scene/real-estate/Rental-Prices-Increase-Nationwide-161569895.html.>
[v] Adams, Dan. Boston Rents Spiral Even Higher. 14 Aug 2012. The Boston Globe. 22 Aug 2012. <http://www.boston.com/realestate/news/2012/08/14/boston-rents-spiral-even-higher/sxzxKHQWw4uwibbyzGbzyL/story.html.>
[vi] Meyer, Brent. Do Rising Rents Complicate Inflation Assessment? 23 Feb 2012. Cleveland Fed. 5 Sept 2012. <http://www.clevelandfed.org/research/commentary/2012/2012-02.cfm.>
[vii] Typical Percentages for Household Budgets. Budgeting Money. 5 Sept 2012. <http://budgeting.thenest.com/typical-percentages-household-budgets-3299.html.>
[viii] Corn, soybean prices shoot up as drought worsens. 20 July 2012. CNN Money. 5 Sept 2012. <http://money.cnn.com/2012/07/19/investing/corn-soybean-prices/index.htm.>
[ix] U.S. Farmers Plant the Largest Corn Crop Since 1937. 29 June 2012. National Agricultural Statistics Service. 5 Sept 2012. <http://www.nass.usda.gov/Newsroom/2012/06_29_2012.asp.>
[xii] Fingleton, Eamonn. Sell in May and Go Away? Not! 1 May 2012. Forbes. 5 Sept 2012. <http://www.forbes.com/sites/eamonnfingleton/2012/05/01/sell-in-may-and-go-away-not/.>
[xiii] Weisenthal, Joe. September is the Worst Month for Stocks. 3 Sept 2012. Business Insider. 5 Sept 2012. <http://www.businessinsider.com/september-worst-month-for-stocks-2012-9.>
[xiv] Leinweber, David J. Stupid Data Miner Tricks: Overfitting the S&P 500. 1995. Caltech. 5 Sept 2012. <http://nerdsonwallstreet.typepad.com/my_weblog/files/dataminejune_2000.pdf.>
[xv] Leinweber, David J. Stupid Data Miner Tricks: Overfitting the S&P 500. 1995. Caltech. 5 Sept 2012. <http://nerdsonwallstreet.typepad.com/my_weblog/files/dataminejune_2000.pdf.>
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