Sunday, January 9, 2011

Real Estate - Already Topped? - Clear Risk Definition

Real Estate based Mortgage-backed securities were one of the primary causes behind the stock market turmoil of 2007-2009. Recently, I came across an article on CNBC "Mortgage-Backed Securities to Save Financials?" (, suggesting that these Mortgage-Backed Securities are making a comeback and one should invest in them.

After reading the above mentioned article, I decided to analyze the Real Estate sector from academic, technical, fundamental and sentiment perspectives. The goal of this article is to decipher the overall state of the real estate market and to clearly define the risk in this sector. 

Mortgage-backed securities are essentially bundles of mortgage loans that are secured by the underlying properties. Such securities caused massive losses at major banks when the housing market crashed.

After extensively studying Mortgage-Backed Securities, it turns out that these securities provide a very clever way of freeing up capital for further real estate transactions. In other words, MBSs foster growth of the Real Estate and the Financial sector. However, introduction of leverage and greed in these MBSs during the Real Estate boom, amplified the inherent risk associated with these instruments. Consequently, after topping in early 2007 Real Estate market declined by 78% from top (2007) to bottom (2009), as measured by the Dow Jones Real Estate Index (a proxy of the US based Real Estate market).

According to these charts, Real Estate Index has retraced 50% of the initial 78% decline experienced during 2007-2009 bear market. This kind of retracement is normal, after a sharp downside move.  

These charts also exhibit an ending diagonal pattern. This rare pattern is defined as, "An ending diagonal primarily occurs in the end, at times when the preceding move has gone 'too far too fast'" (Eliott Wave). With Real Estate Index rising 175% in less than 2 years i.e. approximately 100% per year, current rise can surely be termed as a move that has gone "too far too fast."

Furthermore, after breaking out of the ending diagonal, near-term price pattern (3rd chart) conforms to the definition of a correction rather than a start of new primary up trend. 

Above all, these technical developments have taken place in conjunction with blooming optimism towards the real estate market. For example, introduction of Mortgage-Backed Securities, people recommending Real Estate Investment Trusts on websites and in news, and several other anecdotal evidences. Ironically, this optimism is being fanned at a time when the latest reading of the Case-Shiller index has shown that real estate prices have declined in all major US regions.

Therefore, based on the above mentioned evidences, it appears that the real estate market is at a very critical juncture, along with the broader stock market.

In the event, as I have always mentioned risk management is the most crucial aspect of any investment decision i.e. how to quantify and classify risk. Although risk management is a tough task, current position in the real estate index provides a very unique opportunity to easily quantify risk. In simpler terms, if the above mentioned real estate topping forecast is to hold true then Real Estate Index should not make a new high above the November 2010 high. Therefore, one is only risking 3.7% of capital for a great potential trade. 

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