Real Estate Woes?

Bottom Line: Sharp declines in real estate stocks were warning signs before two of the most severe stock market sell-offs in the past 20 years.

If you even casually follow broad market sectors, you have undoubtedly seen something about housing stocks or REITs (Real Estate Investment Trusts) lately. Over the past few days, the Morgan Stanley REIT Index has declined over 15%, any many housing-related stocks have seen similar haircuts, which is being attributed in some manner to the rise in bond yields.

A study by the Center for Economic and Policy Research suggested that if a national housing bubble would collapse, meaning the average home price would lose 15% - 25% of its current value, it would eliminate somewhere around $1.5 trillion in homeowner’s wealth, which could lead to a nearly $80 billion reduction in consumption, which of course would trickle down to the earnings power of many U.S. companies. Instead of getting into a fundamental discussion about the topic, I would rather stick to seeing how this type of activity has played out in the past.

The National Association of Real Estate Investment Trusts (NAREIT) publishes some information about its indexes of real estate-related stocks going back to the early 1970’s. When we take a look at its index of all REITs compared to the performance of traditional equities, something notable stands out when we put the current move into perspective. Since the end of March, the NAREIT index of all REITs has declined over 12%, which is an extremely large drop – in fact, if the index closes out the month at this level or below, it will be the largest one-month decline in 17 years.

What is perhaps a reason for concern is that since 1971, any time the REIT index declined 10% or more from a new all-time high, the S&P 500 was lower one month later every time, for an average loss of 12.7%. However, there were only three instances, so it’s not like we’re going to get statistically significant results.

The chart below shows the REIT index against the S&P 500 from 1971 through last month. The gray vertical dotted lines show the month that the index declined at least 10% from its prior all-time high.

While it’s a bit difficult to see on this scrunched-up logarithmic chart, the first instance preceded the very difficult market of 1973-1974. The second instance preceded the crash of 1987. The third instance preceded the mini-crash of 1998. The table below details each of the instances of when the REIT index peaked, when it dropped by at least 10%, and the subsequent performance in the S&P 500 the given number of months later.

REIT Index Peak	Declined 10% By	% Decline	S&P 500 Performance
REIT Index Peak	Declined 10% By	% Decline	1 Month Later	3 Months Later	6 Months Later	12 Months Later
Nov-72	Apr-73	-11.5%	-1.9%	1.2%	1.2%	-15.6%
Feb-87	Sep-87	-10.3%	-21.8%	-23.2%	-19.6%	-15.5%
Sep-97	Jul-98	-14.9%	-14.6%	-2.0%	14.2%	18.6%

		Average	-12.7%	-8.0%	-1.4%	-4.2%

The average return in the S&P one month later was an abysmally poor -12.7%, with all of them being negative. One year later, the average return was still a negative 4.2%, though the occurrence in 1998 was very positive.

The figures above use monthly closes in the REIT index, so they do not take into account any intra-month fluctuations. If real estate stocks recover later this month, it’s quite possible that we will not see a 10% decline in the REIT index from its all-time high and this study will have been for naught (unless it continues to decline in the coming months). Still, I believe it’s important to keep an historical perspective, and the precedents for a large drop in REITs after hitting new highs are not promising when we look at their impact on other equities.

Bottom Line: Money going into (or out of) equity mutual funds is correlated to market performance, and with fund flows likely to see a seasonal slowdown soon, some predict market weakness.

This weekend in Barron’s, their technical analyst postulated that the bull market may be nearing an end, giving one reason as decreased flows into mutual funds. I’ve been asked a couple of times whether this is actually true or not, so I thought I would answer the questions here.

According to Investment Company Institute data, after April there certainly is a drop-off in the amount of money that has tended to flow into equity mutual funds, using average data from 1984 through February of this year.

In an average April, nearly $12 billion has flowed into equity funds, but it declines steadily after that. In an average July, for instance, that number is under $5 billion. The scatter plot below shows the relationship between flows into equity funds and the performance of the S&P 500 that month.

The correlation here is 0.32, which is quite large and significant given the number of data points. But there is a chicken-and-egg dilemma – does money flow into equities because they did well that month, or did the market do well because money flow into equity funds? This correlation doesn’t answer that question, all it tells us is that there is a positive relationship between the two and information about one of them tells us something about the other one. In any event, a common argument is that the stock market rises and falls as a function of liquidity, and the more money there is, the higher stocks will go. Mutual fund flows are only one part of the overall liquidity picture, but as we just saw there is indeed a relationship between fund flows and market performance. Since the summer months – on average – see less money flow into equity mutual funds than the first few months of the year, and since there is a positive correlation between fund flows and market performance, some argue that this means the stock market will have less chance of rising significantly after April. As far as the Barron’s piece goes, I cannot refute their claim.

Perhaps more important is whether fund flows are greater or less than average. Over the past 20 years, if money flowing into equity funds was above average, then the average return in the S&P that month was 1.9%. If fund flows were below average, then the S&P showed an average return of only 0.2%. While we can see this all only in hindsight, there is some free information out there – such as from AMG Data – that is released weekly and gives you a snapshot of how much money is coming into (or out of) mutual funds. While an excessive amount of money coming or going is often a good contrary signal, in general you don’t want to see money continually flowing out of mutual funds. With such low cash levels at most fund firms nowadays, when money leaves fund managers may have to sell stock in order to meet redemptions.

Most of our shortest-term measures are mired in neutral, and I cannot find much of an edge to relay for the coming days. As I stated last week, the market action we’ve seen has confirmed what our studies from a few weeks ago were suggesting, and I believe it’s best to assume that we have seen an intermediate-term low. Last Monday, I highlighted the fact that we were grossly overbought in the short-term and moderately overbought in the intermediate-term, suggesting a pullback was likely over the next few days. The selling we saw after that didn’t amount to much, and we’re now back to around the same levels. While some of our indicators became a bit oversold by Wednesday, I didn’t see the type of activity I would prefer to see to establish some longer-term long positions. In this meandering market, I still do not see a real edge in being short or long at the moment, and would prefer to see more weakness before becoming aggressive in entering long positions.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.