Sunday, May 31, 2009

Is the Tipping Point Cyclical, Secular or Both?

How does this Influence the place of Real Estate in the Wealth Portfolio?

According to folklore, the Rothschilds divided their wealth one-third in securities, one-third in art, and one-third in real estate. A recent poll of US millionaires put their real estate investment at one-quarter. Which is the optimum choice? The answer may be found in the analysis of whether we are entering a cyclical or a secular tipping point. In modern usage, a tipping point is that point when change is unlikely to be reversed. The trends of the stock market and those in real estate are not perfectly attuned, because of the liquidity preference, securities prices move faster than real estate prices.

Now that we have completed three consecutive months of stock market gains, many believe (or at least hope) we have passed a turning point that is also a tipping point, as we enter a cyclical market recovery. In my recent series of interviews with mutual fund and hedge fund managers, I have found there is a dichotomy about this belief. Some managers, mostly mutual fund managers, see the market upturn as part of a normal cyclical recovery. For the most part, these are managers that have not changed their portfolios significantly since last summer, if not longer. They believe that the stocks that hurt them on the decline will lead them off the bottom. Led by the financials, stocks have risen. However, a more careful analysis shows the leaders in this recovery are the high momentum or high beta stocks, which suggests that the buyers are more traders than long term investors, perhaps not predictive of a sound long term increase in investment values of high quality stocks and bonds. A number of hedge fund managers are not buying the cyclical recovery story. Some see themselves as asset managers, not more narrowly defined “growth” or “value” stock managers. In numerous cases the asset managers have elected to add high yield debt, bank loans and selective mortgage debt “credits” to their portfolio. The more extreme of these managers are involved in distressed companies’ debt. Along with Moody’s * they expect a sharp increase in defaults well into 2010. Thus, as is common at various turning points, there is considerable debate as to whether what we have seen over the last three months is merely a trading opportunity or not.

The case for a secular tipping point is more difficult to recognize, and if there is one, our focus may be premature. The first place to look is the structures of the financial community. The regulated communities of banks were failing the principles of safety and soundness that allowed them to be both independent and to offer the cloak of government backing. As a result, in many cases they became temporary wards of the state (along with others). Predictably, the banks followed the shadow financial system into debt and equity positions that they did not fully understand, but had no problem selling them on to both institutional and retail customers. At the urging of banks, the government initially wanted to regulate the shadow financial system, but is now increasingly dependent upon the expertise and risk assumption capabilities of the unregulated members of the global financial community. Reluctantly, governments around the world have recognized that risk assumption is much better done in the private sector where the risk of financial failure and possible personal bankruptcy supply a much higher level of discipline than the outmoded rules issued by the government. If this change in attitude is happening, then a major tipping point is close by. If not, the three month turn at best is cyclical in nature.

The real estate market is also currently focusing on a cyclical recovery that will eat into the excessively large inventory in the commercial real estate sector. To look for a secular change one needs to look at the new construction plans. Building “green” is becoming fashionable. One can debate whether the fashion is just a politically sensitive fad in terms of global warming or an honest desire to be more fuel efficient*. Nevertheless, this trend is a considerable change to the production of buildings of all sorts of sizes and locations. However, I doubt that going green is a major tipping point. There is one possible point on the far horizon that would be a tipping point if it were to gain momentum. If we are serious about all kinds of energy conservation (from autos, homes, offices and stores), we need to encourage people to return to the cities. To make this return attractive to people, we must rebuild cities into pleasant, safe and healthy places.

What does this ramble mean to asset allocation between securities and real estate? For securities there is a good chance that we have tipped ever so slightly into a cyclical recovery, which is not at all saying that we are heading for new highs. Only if we see a secular turn in the thinking of governments and their people is there a good chance we will soon move toward new highs. Bottom line is to buy and own securities, but be prepared to sell when the cyclical recovery has been completed. In terms of real estate, almost any sale today will be a good sale . If you do not have to buy, it might be best to wait until both the absorption phase is near over and there are signs of a secular change.

* Moody’s is a position in a hedge fund managed by the author. In addition a portion of said fund will be devoted to securities in the energy technology space.

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