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June 23, 2005

If It Looks Like a Bubble...
by Chad Hudson

UNEDITED

Earlier this month, Bear Stearns published a research report that analyzed past asset bubbles and found there were quite a few similarities. Using these similarities, they were able to construct how bubbles were created, fostered and subsequently deflated. The report found that:

"In short, ample financial liquidity fosters a prosperous economic backdrop, eventually leading increasingly optimistic investors to assume ever-increasing financial risk and engage in speculation. Speculation then evolves into an asset bubble, which subsequently bursts, often bringing devastating consequences for the broader financial landscape."

Bear Stearns separated the bubble environment into three phases, and identified twelve different benchmarks to monitor.

Pre-Bubble Environment
• Easy Money - After years of "ample financial liquidity," money supply growth starts to slow about three years before the peak of the bubble.
• Strong Economic Growth - Bear Stearns found that nonresidential building activity was a great proxy for economic activity and usually peaks two-years before the bubble peaks.
• Prosperity - It should not be surprising that personal wealth accelerates during an asset bubble and peaks when the asset bubble peaks.
• Pricing Pressures Build - Inflation starts rising three years before the peak.

Bubble Peak
• Speculation - Investors "become myopic" and get "swept away by the illusion of continued successes."
• Yield Spreads Widen - Spreads bottom and being rising about eleven months before start of the ensuing recession.
• Pricing Pressures Accelerate - Earlier pricing pressures accelerate and peak a few months after the economy started to contract.
• Short Rates Rise - Short-term interest rates typically trough ten month before the start of the recession and reach a peak about three months after the recession started.
• Yield Curve Flattens - The yield curve usually inverts and reaches the most negative position two months before the start of the recessions
• Business Activity Slows - The above factors lead to slowing business activity. Economic activity remains higher during the year prior to the recession and starts to decline slowly, but once the recession starts business activity decelerates quite rapidly.

Post-Bubble Environment
• Asset Prices Collapse - Typical equity bubbles decline 35% to 86%.
• Recession Ensues

Bear Stearns found that assets bubbles can be fall into four different categories.
• Life-changing: Innovation expected to dramatically impact business landscape. The railroads changed the economy in the 19th century.
• Scarcity: Rare commodity creates mania. The tulip bubble is easily the most famous of this type of bubble.
• Thematic: Popular asset theme becomes popular such as The Nifty-50 stocks of the 1970s.
• Government: Government fuels popularity by providing capital, monopoly, or security. The Mississippi Bubble and the South Sea Bubble are examples of this type of bubble.

Using the ten items that were identified as contributing to a bubble, Bear Stearns counted that eight-and-a-half are currently met. The only criteria that are not currently met are widening yields and they gave easy money only half a check. Easy money conditions only received half a check mark because money supply growth typically starts to slow during the bubble period and while it has decelerated it has not started to decline.

After establishing that the current environment is prone to foster an asset bubble, the report identified potential areas that could be a bubble. The most obvious is real estate. The evidence of a housing bubble has been hashed out numerous times and Bear Stearns views this as the "likeliest near-term bubble." The other the three areas that that appear bubbly are China, hedge funds, and nanotechnology. It views nanotechnology as a possible future bubble and that there remains quite a bit of opportunity. So, short your house, buy a nanotech fund and reverse the trade in three years. Just kidding.

Homebuilders have benefited from the increase in residential real estate. KB Homes reported second quarter earnings of $2.06 per share, 61% higher than last year and 28 cents higher than the consensus estimate. Homebuilding revenues jumped 37% driven by a 20% increase in units coupled with a 14% increase in average selling price to $247,800. Demand in California remains strong with the company reporting that orders were up 30% in the Golden State. Part of the price increases are offsetting higher costs. During the conference call, the company said that "average cost per lot cost are up over 10%" and materials costs are rising 2-3%. Even with these higher costs, gross margins increased 280 basis points to 26.8% due to the higher home prices. This was the highest gross margin for the company in at least fourteen years. Operating margin increased 320 basis points to 13.9%. Backlog grew 52% and now stands at $6.8 billion, which equals the revenue expected over the next three quarters. The company increased it earnings guidance for the full year to $9.00. This is significantly higher than the company's previous guidance of $7.88 and the consensus Wall Street estimate of $7.97.

Lennar's results were also impressive. Its revenue jumped 25% comprised of a 10% increase in average price and a 15% increase in deliveries. We have discussed that the economies on the two coasts have been stronger than the central part of the country. Lennar's orders provided further evidence that this dynamic continued to exist during the second quarter. Its orders in the East were up 15%, 16% in the West, and declined 5% in the Central. This was similar to KB Homes as well. Orders in the Central region were up only 3%. Lennar disclosed that of the homebuyers that used its mortgage division, 53% of buyers opted for adjustable rate mortgages. Of those, 83% had a fixed interest rate period of between three and ten years. Raised full year EPS estimates to $7.15 to $7.80 from $6.90 - $7.15. The company is expecting the average price to escalate to $325,000 by the fourth quarter causing gross margin to increase to 25.6%. "27% of the total loans are interest-only, and we've certainly seen a preference for people to go down this path." California accounted for the "bulk of the increase" of new orders in the West.

At the other end of the spectrum are the domestic automakers. After reducing earnings estimates earlier this year, Ford lowered its earnings forecast for 2005 by a quarter to $1.00 - $1.25 per share due to "weaker North American automotive results." The automaker will also eliminate 5% of its salaried positions and eliminate bonuses for salaried management and 401(k) contributions for all salaried employees.

Because of the bifurcation of the economy, it is difficult to gauge its strength. As long as the housing market remains strong, consumer spending will likely remain robust. If the real estate market is in a bubble, the results will have a much larger impact on the economy.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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