Lee Adaptive Strategies Update
March was a good month that had the misfortune of capping a poor quarter. The S&P 500 was up 3.71% on a total return basis for the month, but still gave up -4.60% for the first quarter of the year.
Several media outlets pointed out that this was the first down quarter for the index since March of 2020, the implication being not that it has been such a long time since this has happened, but that a losing quarter for the S&P is an extraordinary event, something that would be caused by a pandemic-level crisis. Indeed, this was only the fourth red quarter for the S&P in the twenty five quarters since September 2015.
March certainly had the feeling of a joyless bear market rally. The two fearsome stories that presumably drove January and February’s losses, Fed actions to raise rates and the war in Ukraine, continued without much in the way of good news. At best, the outlook became incrementally better because the situation did not grow much worse.
Investors have become resigned to the idea that the market went up in March for the same weak fundamental reason it has gone up in so many months recently, by the process of elimination. This has lately been called TINA, or There Is No Alternative, meaning that US equity is the least bad choice. Fixed income is obviously challenged in a rising rate environment. Non-US equity is more exposed to the war. Commodities have already rallied strongly and are much riskier now. Even cash is less attractive given high inflation. That leaves the one usual suspect, which also benefits from the questionable lesson of 2020, that in times of uncertainty it pays to invest in the largest US companies.
Of course, to ordinary American households, there does exist an alternative that often dwarfs their allocation to US equity. For the nearly two thirds of households that own their home, that home is generally their primary asset. And houses have had quite a run lately.
For the twelve months ending January 31, 2022, the Case Shiller National Home Index was up 19.16%. That is not as much as the 23.29% that the S&P gained over the same period, but in the context of the Case Shiller Indexes it is historic. Prior to COVID, the highest year-over-year gain since the index’s inception in 1988 was from September of 2005, when the overheated housing market that would in a few years collapse and take the world economy with it gained 14.44%.
Moreover, it is worth reminding ourselves that houses are almost always purchased with what would be considered an irresponsible level of leverage in the stock market. Putting 20% down, and thus getting a 5X exposure to price movements, is actually considered conservative in housing. The consumer who bought a house a year ago with 20% down has now very nearly doubled his investment.
As the housing bubble and Financial Crisis are now fifteen years in the past, it is probably a good idea to review how the Case Shiller Indexes work. As might be expected from an index developed by two economics professors, the methodology is both highly accurate and notably untimely. To begin with, the indexes are reported two months in arrears, meaning that the number just announced at the end of March is the end of January reading. Further, the indexes are constructed using a three-month rolling average, so the January level is actually based on the average of price observations from November, December, and January. And those price observations are from houses whose sales closed in those months, not from agreements to sell, which are generally reached one or two months earlier. In other words, the index number just reported a few days ago is based on prices set last fall.
It does not take very much creativity or insight to imagine why the US housing market might cool, or even why it may already be cooling. For most households, the meaningful cost of a house is not the sales price but the monthly payment, which is for practical purposes determined by the interest rate on the mortgage. And those rates have been rising sharply. The average rate for the bellwether 30 year fixed conforming mortgage ended March at 4.67% up from 3.11% at the end of last year. That means that the monthly payment on a $500K mortgage has just gone from $2138 to $2584.
And yet anecdotal evidence suggests that the housing market is not cooling. The number of houses available for purchase is down sharply, with listings on Zillow ending February -12% lower than January, -26% lower than a year previously, and -53% lower than the end of 2019. Media, social and otherwise, is full of tales of a buying frenzy, with inspections being waived and offers over asking made before open houses.
Is this a bubble about to burst? We are not so sure. A rising mortgage rate is certainly very bad news for the housing market. But rising inflation is very good news. As jarring as a 5% mortgage may be compared to recent norms, with inflation over 7%, it is still a negative real rate. Buying a house a year or two ago would have been a much better deal than buying one today, but buying one today is still an attractive proposition.
Attractive, that is, providing you believe that the house will hold its real value and appreciate at least at the rate of inflation in nominal terms. That is probably a good bet, but as the experience of fifteen years ago taught us all, it is far from a certainty. Then again, there are few alternatives.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant anduncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Optimism continued its slow drift downward in March, while Efficiency rose slightly, while staying within the range it has inhabited for six months.
Optimism began the month at -0.35 and ended at -0.54. Although it has decreased steadily since mid-2021, Optimism is well above its pandemic lows seen in the first half of 2020.
Efficiency rose, starting the month at -0.21and ending at -0.09. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress.
Both measures are higher than where they were in early 2020, but have trended lower since spring 2021. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
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By: Nathan Eigerman