Bill Smead: "The Big Long"

"The Big Long"

by William Smead, Smead Capital Management

I recently saw the movie, The Big Short. While the movie entertained as much as the book, the movie’s release coupled with the rough start to the year probably left a lot of investors feeling anxious. As long-duration common stock owners, we at Smead Capital Management believe a review of the circumstances preceding the financial meltdown of 2007-2009 and a comparison to where we are now in the U.S. economy would be helpful. Since residential real estate was the centerpiece of the movie, and traditionally is a centerpiece of our economy, we will dub our current view as “The Big Long.”

The Big Short is the story of a small group of financiers who dissected an upcoming debacle in residential real estate and figured out the most effective securities to own to take advantage of the coming meltdown. They purchased securities which grew in value by billions of dollars when home owners walked away from payments on homes they couldn’t afford.

At this time, let’s step back and see what laid the groundwork for a collapse in nationwide home prices and produced massive mortgage defaults:

1. The 09/11/2001 attacks

   The U.S. was attacked by Al Qaeda, who hoped to cripple our economy. In response, the only sensible thing to do as a nation was to generate solid economic performance. The Federal Reserve Board provided extremely accommodative monetary conditions and low interest rates, while the Bush administration started ramping up defense efforts and attacks on our enemies in the Middle East.

   The combination of an easy Fed policy and stimulative fiscal spending helped the economy pull out of the recession triggered by the bursting of the tech bubble in 2000-2001. We have argued that some cleansing of the economy in 2001-2002, which would have happened without the low interest rates and stimulative fiscal policy, would have been the healthiest thing we could have done. However, household debt service ratios did not come down before the 09/11 attacks and the normal cleansing which would have come from more conservative behavior in relation to borrowing never occurred.

2. Demographics were inevitable

   There are approximately 25% fewer Americans in Generation X (“Gen-X”) than there were/are in the baby-boom generation (“boomers”). At some point, the U.S. housing market was going to be negatively impacted by the absolute numbers. As is usual in the economic history of the U.S., difficult demographic and labor economics get solved in crisis situations. Wars and depressions in the 20th century accelerated the decline of agricultural employment in the U.S. The same was true for housing as the much smaller Gen-X group replaced boomers as the main source of new housing.

3. We overrated home ownership as an investment

   In the aftermath of the tech bubble bursting and a 40% decline in stock prices from a record high at the end of 1999, American investors were happy to overestimate the financial benefits of owning residences. Studies show numerous family and long-term financial benefits to home ownership. It defends you against housing inflation, it builds equity, provides family stability and is a bedrock of citizenship in the U.S. However, it has its ups and downs, is highly leveraged and has no history of competing with common stock ownership from a historical return standpoint.

4. Cable TV popularity and 500 channels

   Hannibal Lechter told agent Starling in the classic film, Silence of the Lambs, “Buffalo Bill covets what he sees.” Americans saw numerous shows on investing in homes and on attractive vacation homes. The coveting ended badly; for fans of the Ten Commandments, this was no shock.

5. Mortgage industry stupidity

   Executives at most major financial institutions and their regulators fell asleep at the wheel. Conservative down payments, income verification and high debt service levels were ignored. Almost everyone in the U.S. got caught up in the housing bubble and those who argue that it was all the bankers fault are revisionist historians. One of the populist premises of the candidacy of Bernie Sanders leans heavily on trying to make average Americans forget that they were greedy and voluntarily stupid from 2002-2006 in the residential real estate market. As someone once said, “it takes two to tango.” When it came to the housing bubble, it took 150 million willing Americans to tango with the financial institutions and missing-in-action regulators.

6. Oil prices skyrocketed between 2003 and 2014

   Household spending was crippled by a huge gasoline price increase and the average household’s psyche was severely damaged by the run-up at the pump. Not only had the most valuable investment (one’s residence) been pummeled, but oil producers poured massive salt in the wound.

If the horrendous confluence of events prior to 2007 triggered the worst economy and financial meltdown in history, what might today’s set of circumstances cause?

1. The household debt-service ratio is the best it has been in 36 years. This means households can expand their indebtedness for important purchases like houses and cars.
2. There are 86 million people between 20-39 years old and the majority have yet to marry, have kids and buy a house. They are immense in relation to Gen-X and should overwhelm previous demand.
3. We are under-estimating home ownership benefits. The average rent costs 30% of gross income and the average mortgage costs the average household 15% of gross income monthly.
4. The bearing of children will become a boom and homes will be bought for the right reasons. Screaming babies and toddlers need a yard.
5. Mortgage lenders are being very conservative and are over-capitalized. They are ready for the Millenials to become much better customers. Regulators breathe down the neck of mortgage industry executives. Bank executives are vilified whether they were the problem during the bubble or not. In The Big Short, the CEO of JP Morgan, Jamie Dimon, is pictured as a villain. In reality, his company’s financial strength and conservative management allowed them to absorb Bear Stearns and Washington Mutual, two of the federal government’s biggest problem children. JP Morgan and Wells Fargo only took TARP money to facilitate the healing process, they had no need of the money on their own.
6. Cheap gas makes longer commutes tolerable. Tech-oriented workers and other companies could migrate to less expensive regions to enjoy affordable housing and a healthier lifestyle. RBOB, the name for gasoline futures, trades around $0.95 per gallon, but peaked in June of 2014 at $3.12 per gallon.

We think the current circumstances could lead to a much better economy over the next ten years than most people imagine, and an all-in long position on the U.S. economy would be the “Big Long.” In the movie, the smart investors who put on the “Big Short” were right about the mortgage defaults, but the securities they bet against did not plummet until a year later. We get a great deal of push back right now because the common stock market doesn’t agree with us. We are undaunted like Christian Bale’s character was in the movie.

Sincerely,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

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