Mike Shepard's Realestate News Letter: October 2012

“There are known knowns; there are things we know that we know.
There are known unknowns; that is to say there are things that, we now know we don't know.
But there are also unknown unknowns – there are things we do not know we don't know.”

Donald Rumsfeld, United States Secretary of Defense, commenting on Iraq in February, 2002

SUPPLY AND DEMAND

Just to quickly review last month’s discussion, there are those (I’m a member of this group) who look at the current set of circumstances in housing, primarily supply and demand, and feel pretty certain that the market has no place to go but UP. Housing is famously a “local” market, which our fascination with national numbers sometimes obscures. In Orange County it continues to be a seller’s market—and now a pretty strong seller’s market. As the attached graph continues to show inventory is constrained, buyers remain strong and aggressive, and I don’t see that trend reversing any time soon.

But, there are also those wringing their hands and holding forth that such optimism simply fails to grasp the clear and present dangers ahead—some combination of the “known unknowns” and, even worse, the “unknown unknowns,” maybe even the Black Swan events and their societal changing impact. (Nassim Nicholas Taleb authored a book in 2007, “The Black Swan: The Impact of the Highly Improbable.”)

In the area of the “known unknowns,” there are those very sure that there’s a shadow inventory out there that is going to cause enormous disruptions on the supply side. This “shadow inventory” remains a “known unknown.” There are those who extrapolate and conjecture to quite specific numbers of the components of the “shadow inventory,” but when you dig into it you find a surprising fuzziness in the actual “known” numbers. I had planned to continue the discussion on the “shadow inventory” this month because there have been some developments that I think makes the forecast of major supply disruptions from shadow inventory increasingly unlikely. (See the second attachment above for one example.) Instead I’ll focus this month on a question, or actually multiple questions, that seem to be scaring the socks off about half the people with whom I talk regularly.

HOW BAD ARE THE UNKNOWNS?

One of the things that has struck me over the last couple of months is the sharp difference in outlook among the people with whom I am blessed to converse with every month. At one point I thought that the folks who think everything is headed UP must be the ones whose income streams and standard of living were not impacted by the events of 2008. They saw the pain of others “outside,” but suffered no such pain inside their own walls. But, that clearly isn’t the driver. In fact, I can’t see a pattern based on anything, not on the amount of economic disruption suffered over the last four years, or by generational differences, or by gender, or by any other criteria. Inevitably the folks wringing their hands seem focused, or at least keenly aware of the headline worries, both the “known unknowns,” and the “unknown unknowns.”

And, I can understand why. I follow a great deal of “news,” or at least what passes for “news” now days. There is no shortage of hand wringing worrisome news stories; Europe—a vast field of the “known unknowns” and “unknown unknowns” tied to the “great unknown,” how will the “wheels coming off the cart” of Europe impact the U.S., and how soon? Same questions, somewhat different worries as to the future of that great economic engine, China.

Add in the current dual focus of the 24/7 news cycle; the elections, and the “fiscal cliff” and it sometimes might seem too much a challenge to go ahead and open your eyes and hop out of the bed every day. And, all the above collection doesn’t even include the current or future antics of the Federal Reserve Open Market Committee which, to me, seems to be a bunch of smart guys holding a handful of “known unknowns” in one hand, and a handful of “unknown unknowns” in the other hand clapping both hands together and pronouncing them as “known knowns.”

HOW WILL YOU HANDLE THE UNKNOWNS?

I was thinking the other day about the similarities of the current worries to those of Y2K. Do you remember the lists of “known unknowns” being creatively dramatized into lists of enormous Black Swan type “unknown unknowns?” What happened as THE EVENT came and went? The “known unknowns” became something of a yawn, and the wild eyed “unknown unknowns” became sheepish embarrassment. The number of puzzle pieces in today’s game, and the way the pieces fit together make it hard to draw a direct correlation to Y2K, but I can sure see a lot of the same sorts of mental gymnastics going on.

I was talking to someone recently who was anxiously climbing “the wall of worry,” jumping back and forth between the “I should really go ahead and do something now,” and the “what if this, that, or the other thing really does happen in the next six months,” and the stock market collapses, the housing market collapses, and …on and on. If you find yourself in the same predicament he was in my suggestion to you is STOP—DO NOT MOVE FORWARD RIGHT NOW. It just isn’t worth battling that wall of emotion. The election is in a month. The fiscal cliff will be handled in 2-3 months—or, more likely, postponed and handled over the next 6-8 months. Then, in the light of a new year, a new Congress, a new Administration, and a calmer you, you can move forward without driving yourself crazy. (If you’re waiting for the unknowns of Europe and China to become “knowns” before you move forward then buy some good books and settle in for a long rest.)

For those who are convinced that housing is headed UP, I agree with you. It probably won’t be a smooth one direction trend line, but it never has been. The “knowns” that I see in Orange County, California, point to UP. The “known unknowns” that I see will absolutely make a difference over the next year, but I just don’t see it reversing the supply and demand trends of 2012.

WHAT A COUNTRY!

I was thinking of that famous line that the Russian immigrant comedian, Yakov Smirnoff, used in his stand-up routine in the 80s. When we think back on the events of the last five years, when we sort through the nonsense that passes as political dialogue now days, we have to be awestruck that we are blessed to live in the greatest country to have ever existed, a country that no matter how messy and irritating it might be getting there, when we start our day on November 7^th we will have a President, and a Congress freely elected by free people. They will assume their offices in an orderly and peaceful manner. Our businesses, our homes, and/or our lives will not be endangered because of who won or who lost or which side we were on.

NOW THE “HEADLINE NEWS” HAS EVEN CAUGHT UP

At the beginning of the summer I wrote that “the statistics have caught up” with what had been happening “on the ground” in Orange County real estate since February. I used graphs showing sharp inventory corrections across the board, and striking inventory shortages in various market segments in various cities in Orange County. As the summer wore on we had to recognize that the sales and inventory numbers were clearly breaking out of the range of “anomaly,” and into the definition of a “trend.”

Over the last month it was hard to miss the numerous news reports; big cable, major network, local papers and countless blogs “caught up.” And they caught up fast. I don’t think there has been one day in the past month that I haven’t seen a report talking about the strength of the real estate market, often with the word “surprising” in the description. The first graph attached to today’s report clearly shows the length and strength of this trend in Orange County.. (While the story might be the same, better, or worse in markets all across the country I am, for this report, focused on our market here in Orange County.)

DRAMATIC SHIFT IN DISTRESSED INVENTORY

Continuing the discussion from last month on the “shadow inventory,” a topic that seems to quickly creep into every real estate discussion, please take a look at the last two charts attached. The two 4 year charts of active listings, versus pended sales, versus sold, the first being for all distressed* resale residential in Orange County, and the second for all standard resale residential sales in the county just have to grab your attention. Digging through the data a little deeper yields some interesting data points. (The graphs show total active inventory, not new listings.) As the graphs show, standard sales have been generally increasing, and distressed sales have remained fairly constant. But the dramatic shift has been in distressed* listings coming to market. For the six months ended at the end of August, in 2009 there were 4352 new distressed listings, in 2010 it was 4484, in 2011 it was 4050, and this year it was 2819. These are Orange County statistics. But, since we are impacted by the national news and opinions let’s take a look at a few of them.

*Distressed properties include all houses in foreclosure, in notice of default, and short sales.

THE FOLLOWING THREE PARAGRAPHS MENTION AN ANALYST NAMED A. GARY SHILLING. HE IS ONE OF THE MOST ARTICULATE OF THE “BEARS.” I DISAGREE WITH MOST OF HIS ANALYSIS AND FORECASTS, BUT

HE IS A HIGHLY RESPECTED ANALYST WITH A PRETTY GOOD TRACK RECORD, NOTWITHSTANDING SOME GLARING MISSES. BUT, ALL THE OUTSPOKEN FORECASTERS HAVE THEIR SHARE OF MISSES. I’M RELUCTANT

TO SINGLE OUT ONE ANALYST BY NAME, BUT DO SO WITH RESPECT, AND I HOPE THAT COMES ACROSS IN THE FOLLOWING DISCUSSION.

The state lawsuits ended the “robosigning” mess in February (coincidentally the month that our positive trend lines seem to begin). This was supposed to set in motion a big new round of foreclosures, put on hold during the lawsuit, which would flood the market with a huge excess inventory of housing that Gary Shilling keeps saying is inevitable. (Gary Shilling gets and deserves a lot of credit for accurately predicting the housing crises of 2007/2008. However, we should remember that in July, 2011 he confidently predicted, based on what he insisted was still two million excess housing units, and that an imminent 20% collapse in home prices would lead the nation into a severe recession in early 2012.)

However, as the nightmare of 2008 was coming to an end the most aggressive estimates I remember were three to three and a half million excess units. For four years the industry has built a half million below the norm (that’s the long term norm, not the exaggerated norm of the early 2000s). So, we have absorbed something around two million of the excess already. In last month’s report I got into the discussion about all the owners who were upside down and, it was assumed by many experts, would “strategically” default. But, it turns out that “HOME” means something a lot deeper to an American homeowner than a line on their balance sheet, and the percentage that are using the “strategic default” is pretty small. Now, as we move into the fifth year of our “housing crises” it appears that there’s a concerted effort by the FDIC and the major banks to “slow walk” their way out of the rest of their “special assets” (foreclosures). Bottom line; every time I try to get into the “shadow inventory,” I keep coming up with numbers, at least for Orange County, that, if they all came to market at one time, would amount to several months of inventory, not the several years that Gary Shilling, and others, to be fair, keeps talking about.

The bulls and bears who analyze, write and speak on this shadow inventory usually have lots of acronyms after their names and really expensive software programs to do their analysis. (Yet they still come up with exact opposite conclusions.) Gary Shilling could be right about another two million units of “shadow inventory,” and another 20% drop in housing prices, and about a major recession starting earlier this year accompanied by a major stock market correction. But, if you followed him in July, 2011, you lost a lot of upside opportunity in both real estate and the stock market while hiding your money under your mattress. One of the reasons I’m writing this is to try to interject some street view common sense into the constant parade of the “talking class” on our 24 hour news channels. We have to be careful, but there’s a point where careful turns into paralysis, and usually at the exact wrong time.

#1 QUESTION I HAVE BEEN ASKED DURING AUGUST

Over the last month I have been repeatedly asked one or another version of, “What will happen to the market when school starts and the summer selling season ends?” Great question—at least I thought. To answer that frequent question I started “digging deep” into ten years’ worth of numbers. To my surprise I found only the very skimpiest of evidence showing a hard pattern of the strong summer sales period versus the weaker fall/winter sales period. Further, there were numerous months completely out of sync (a strong month during the winter or a weak month during the summer), further undercutting this already weak pattern. (There is a more recognizable pattern in “listings” than in “sales.”) No doubt a statistician could pick out a pattern with some percentage predictability attached. But, for a normal person just trying to make a decision on buying or selling a home I could not find a pattern anywhere near strong enough to use as a factor in your decision making process. Further, if a person did want to use the listing pattern it is clear that 2012 is a contradiction. The “pattern” style increase in the number of listings in the second quarter certainly did not happen this year.

We now head into fall with a shortage of listings in the most sensitive price ranges in broad sections of the county—glaring shortages in the lower priced condominium market. From my perspective—from street level—it looks like we’re likely to see slowing sales in the next two or three months, but not because of anything having to do with the end of summer or the beginning of school. The sales this fall will be impacted more than anything else by a shortage of the inventory! What a change!

#2 QUESTION I HAVE BEEN ASKED DURING AUGUST

You might have guessed it, “What will happen after the election?” This election can have a profound impact on who and what economic philosophy occupies the Executive Branch, the House of Representatives and the Senate at the national level, and some pretty important economic decisions at the state level. If you and I were sitting together we might spend several hours dissecting the different outcomes of this election. And, hand-in-glove, the aptly named “fiscal cliff” ties directly to this election. For sure, it is impossible to watch your choice of cable news without seeing multiple political commentators waxing eloquently on this subject. Whether there will be any kind of fundamental shift in supply and/or demand in the 1^st or 2^nd or 3^rd quarter of next year as a result of the election outcomes is still pretty foggy to me.

I have read dozens of expert forecasts—political, economic, and combined, with very different conclusions and forecasts. Most all of these pundits have an exuberant confidence in the accuracy of his/her forecast. The pessimistic “bears” have ample logic for their scenario. But, the optimistic “bulls” have equal logic for theirs. Since they are noticeably contradictory there will have to be about as many wrong as right. In the true spirit of the talking class we will certainly know which ones are right a year from now—they will remind us. (Ironically, many of the ones who are wrong will find a way to spin the results to make them look right after all.) I have to report one simple answer to you; I don’t know what the results of the election—or the fiscal cliff—will be in the next few quarters, or the impact on the 2013/14 housing market. (You can also put Europe and China under my “I don’t know” heading.)

The first Professor of Economics was hired by Harvard University in 1871. Prior to that “economists” had to “live their talk,” so to speak, and reside in the world of their theories. I wonder if creating a whole new class of the “academic economist,” a class of “expositor in theory,” residing in the comfort of lifetime tenure followed by generous pensions, and shielded from “living with one’s mistakes” has served us well. F.A. Hayek said, “We shall not grow wiser before we learn that much that we have done was very foolish.”

IF YOU’RE SITTING ON THE FENCE YOU HAVE TO SERIOUSLY CONSIDER THIS TIMING OPPORTUNITY

I’ve read reports that even though this has been a good summer in various markets around the country, we’ll continue to “bounce along the bottom” for another year or so. There are still experts, expanded upon above, insisting that we are about to be hit with a huge inventory of “shadow inventory” which will pressure prices again. But here’s the reality of what the numbers are telling us about the last six months, and where we are today. If you’re thinking of SELLING, this is the most favorable market for you in at least six years. Might it get even better, or worse, or just bounce along? Yes, it might. If you’re thinking of BUYING, particularly using financing, this is the most favorable market for you in at least four years. Might it get even better, or worse, or just bounce along? Yes, it might. Looking back on my own career, or my whole life for that matter, I have let slip many a good opportunity in the here and now by over-thinking the unknowns of tomorrow. Repeat: We have to be careful, but there’s a point where careful turns into paralysis, and usually at the exact wrong time.

INVESTORS: I have opportunities, big and small. I watched a small one get away last week only because I didn’t have an investor lined up and waiting to go. It was a one bedroom condo in a great area, came to market at $150,000, sold in three days (all cash) for $165,000. It rents for $1300 a month. How does that stack up against what you’re getting on your money now? Do the numbers—then call me—please? There isn’t a week that I don’t see at least one of those.

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