Waiting for "The Hating" - Asset Cycle Revisited

Posted by jeff

Fri Jun 20th, 2008 01:16 PM

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Back in September of last year I wrote a piece called the Psychology of Asset Cycles. In it I tried to lay a roadmap for the housing bust, as well as a guide to the progression of various asset bubbles and the psychology of greed and fear they inevitably produce. I think it's time we revisit the key elements of these cycles and try to identify where we are on the continuum of Euphoria and Depression.

I am a believer that there are several important cycles taking place in the world today. There's an agriculture cycle, a commodity cycle and an oil cycle. There is also an emerging markets development cycle. Fear and greed are reflected in how all these trends proceed and are eventually self limiting (they eventually burn themselves out). But in this piece I want to focus on the residential housing cycle, not the stock market, not the economy, not the credit cycle and not the commercial real estate cycle. The reason I think it's key to home in on the residential housing cycle...pun intended....is that it's the key driver of the other four right now and although they all impact each other with important consequences, I think the root cause is important to stay focused on.



So where are we on the continuum? In my prior piece I gave some milestones seen in other cycles that I think are really important to reflect on. On the way up the cycle there is, The Lift-Off Phase, Leveraging Up & Relaxing Standards, Fraudsters Pile On/Big Business Plays Along. These were all elements of the recent residential housing cycle, starting with many years of moribund growth in the 1990s and a lift off phase after the tech bubble burst. They correspond well with the Optimism, Excitement, Thrill and Euphoria emotional aspects of an up-cycle.


"The Fed Raises Rates" phase is what starts the decline in the cycle. It is the beginning of the Anxiety, Denial and Fear emotional states of the down cycle. These parts of the cycle are typically when Skinny Dippers Get Caught- skinny dippers being those market participants that got caught up in the excitement, thrill and euphoria and threw caution to the wind or significantly ignored the risks of their business practices. The latest cycle was like a swim meet at a nudist colony; the list of companies that got caught with their pants down is too long to go into but Rating Agencies, Bond Insurers, Mortgage REITs, Mortgage Brokers, Mortgage Insurance Companies, Banks, Investment Banks and Hedge Funds were all part of the rogues gallery.....and man were they ugly in the buff.

The next phase is an interesting one I call No One Gets Out Alive. It usually takes place during the Desperation, Panic and Capitulation aspects of the cycle, because the market has become such a mess that people are prematurely groping around for a bottom. This is the part where even experts in the asset class get burned because the asset class has grown to have so much gravity in financial markets that they get sucked in. It may be that an investor group resisted investing in the area all through the upturn, only to plunge in at the very top, or that they come in after the peak and try to catch a falling knife, getting impaled in the process. Examples this time around are Carl Icahn's investment in WCI Communities, sovereign investment funds' investments in big banks.....they didn't realize that they were not investing in the "credit cycle" - they were investing in the US residential real estate cycle. The huge gravity of this asset class has trumped all. Lehman Bros., most recently, thought they were hedging their risk in the markets and still got side swiped primarily by $2.4 billion of "adjustments" in residential mortgages.

These phases often overlap. The No One Wants To Get Caught Holding phase has been one of the most important phases of this cycle. Banks and brokers have lost faith in each other's balance sheets, because they all know there are many "old maid" cards in circulation and no one wants to get stuck with them. It goes without saying that big pension funds, mutual funds and other market players are equally disinclined to trade with these organizations. The Bear Stearns debacle was perhaps the best example of this kind of behavior.

Eventually we come to the latter parts of the down cycle which include the inevitable Closing The Barn Door. This part of the phase is usally concurrent with the emotional response of Capitulation. Essentially, the cops come and people start to have to admit to what happened, there are consequences and anyone holding on to last hopes of things going back to the way they once were are finally disabused of these notions. Those who may have been trying to ride out the storm are removed from command and the capitulation phase can really begin. I would argue that events like the firing of Ken Thompson, the CEO of Wachovia, is one of the markers of this phase. Here is a guy who bought what was once a great company (Golden West) at precisely the wrong time in the cycle, while also allowing his bank to get very aggressively into risky construction lending. He hoped to ride out the storm, but instead a new team will likely come in and throw in the towel on bad investments. This is also the time in the cycle when politicians finally realize what has happened, determine that it should never be allowed to happen again....and the political machinery finally grinds through enough rotations for the government to do something colossally stupid to prevent a recurrence. The new regulation or legislation usually has the unintended consequence of making the asset downturn even worse. Now we have not really seen this phase play out in full yet. We got some whiffs of it earlier this year, which I chronicled in my piece "Regulator Revenge: There's a New Sheriff in Town", but we are starting to see this phase begin in earnest. An additional feature of this part of the cycle is that some heads must be taken. Some of the players involved in the excesses of the up cycle get publicly punished. I would aver that the arrests of the Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin last Thursday were a clear marker that this phase of the cycle is now in full swing. Before it's all over their names and others will enter the lexicon like Bernie Ebbers and Ken Lay did post the tech stock bubble. Not unexpectedly, this comes at the same time that Senate is getting serious about considering some housing legislation. Regarding this legislation, the Office of Management and Budget warns "The federal government must not prolong necessary corrections in the housing market, bail out lenders or subsidize irresponsible borrowing and lending at the expense of hard-working people who have played by the rules,." CLASSIC! Meanwhile, the power struggles have begun regarding which regulatory bodies will grow and which will languish as a result of the re-regulation of the financial markets. The re-regulation will have huge impacts due to the size of the markets that need to be brought to heel. According to a recent Marketwatch.com article, "The shadow banking system grew rapidly during the past decade, accumulating more than $10 trillion in assets by early 2007. That made it roughly the same size as the traditional banking system, according to the Federal Reserve."

It is no coincidence that residential home prices are now plunging in some of the most overbuilt areas - even while less over-built areas seem to be stabilizing. The capitulation phase in residential real estate has begun. Paul Kasriel writes in an article on the Market Oracle web site "According to Federal Reserve flow-of-funds data, homeowners' equity dropped by $399 billion quarter-to-quarter in Q1:2008 and $880 billion year-over-year - both record absolute declines. The chart below of the Case Shiller composite through May 2008 is one of a textbook barf out (pardon the color).



The final phase of an asset cycle is the one I call "The Hating." On our chart it corresponds to Despondency and Depression. You know this phase has arrived when people don't even want to talk about the asset anymore. The bears cling to the notion that the asset will go into an even more cataclysmic downturn (usually driven by the capitulation itself and the inevitable regulatory/legislative screw ups), the Bulls get tired of fishing for a bottom and things just start to get quiet. I can't see bus tours of foreclosed neighborhoods figuring strongly into "The Hating" phase. So I am currently watching the capitulation phase for signs of boredom.

After the bubble phase it doesn't always take a long time in the depression hope phase for the asset to start acting "normally" again, but I mean long-term normal. With 11 months of single family home inventory on the market, it may take a while for stabilization to follow capitulation. It may take decades before a bubble phase develops again.