Tuesday, August 29, 2006

Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:


Housing Slump Won't Mow Down Spending

UBS Investment Research


WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist

Monday, August 21, 2006

Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:

Housing Slump Won't Mow Down Spending

UBS Investment Research


WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist

Friday, May 12, 2006

Finer Points on Writing Option Contracts

I am liking the idea of writing calls and puts closer to expiration. The time decay is uneven. The closer to expiration, the faster the decay. When selling, time decay is good, just as it is bad when buying. So, the best annualized returns usually occur on the shortest dated contracts. I haven’t found an exception to this rule. Also, short dated contracts minimize exposure to dividends and their effect on contract prices. Plus, short contracts are more likely to capture short swings in stock price. For example, Apple and Armor Holdings, which I have held for 30 days, are falling apart. One week ago, they were looking good. The longer you hold the underlying stock, the more likely something fundamental is going to change. Oil could break down in the next 90 days as natural gas has (though not likely), but you will be locked up if you write for September, although, if it moves away from you (down if you are writing a call), the cost of closing out gets cheaper. I closed out of my GM options and reloaded at a higher price to capture some more premium to help offset the loss on the underlying. BTW: you saw that Jim Cramer came out with a BUYBUYBUY on GM on Wednesday (AFTER the 30% move)? He is predicting $40 in 12 months. Sounds like a good reason to be short to me.

I would like to be able to capture the most gain from writing in the shortest period possible. Even 0.60 per contract looks good when over just 10 days, on an annualized basis. Do the numbers in my spreadsheet and you will see what I mean.

What about the precious metals? I am thinking of selling half my PCRDX and VGPMX. I will definitely pull that trigger if gold hits $800 and maybe sooner. Precious metals have become very speculative meaning that when they go down, they will go down fast. I would like to capture some gain before then, and buy back in after the correction.

Covering Shorts on GM

Well, I couldn’t stand the pain of being short GM any longer, so I took cover.

This morning, I put in orders to buy calls for GM to protect my hiny from any more abuse.

I bought (8) June 30 call contracts for 0.50 each and (10) September 30 call contracts for 1.10. If the worst happens, and GM goes to 30 in the next 30 days (could happen with as many people want to see GM work out, and also, the US market index funds must buy GM as more people buy into those index funds), I sell the June 30 for maybe 2.00 and the Sept 30 for maybe 3.00. This will give me around $3200 in coverage, which just about offsets my losses on the short positions from today, with GM at 25.80 (30-25.80 = 4.20 x 800 = $3360).

On the other hand, if the market gets its senses back and GM goes back down to $20, I will lose the call contracts that cost me $1500, but also be able to continue writing sell orders on my 800 GM shares at about $1000 per month. So, this won’t work out as well as I originally hoped, but at least I don’t lose my rear (and will be adding to profits after two months).

If GM does get to $30 and I sell out my positions, I will be buying naked put contracts against GM, that is for sure.

Next time I try one of these covered puts, I will buy my long dated call at the same time to stop losses at 15%. I would already be in the money if I had done that with stock at $20 in mid-April (a 50 cent Sept contract at 25 then would now be paying $2). It takes about 5 months to pay back a 15% loss (at 3% gain a month on writing the put), but I can live with that. This also points out the difficulty of any bet on the short side, which you already appreciate. The market is biased to the long side.

Brian

P.S. GM proudly made the big announcement this morning that they are raising prices on new cars because they are losing too much at current prices and having to dump unsold cars on the rental fleets. Good luck! This will shrink their market share even more, creating even more labor problems and closing more production that must be capitalized regardless. If they weren’t selling enough cars at the lower prices, how does raising the price help? They don’t have a variable cost structure so this can’t possibly work. They will sell even fewer and will find themselves with as many excess vehicles but with lower total revenue at fixed expense. STUPID!!