Real Estate's Top Looms

Treat this trade with care, because I don't believe that now is the time to put it on. Shorting should not be confused with heroism, as heroics erode capital. I will likely short the mortgage insurers at some point, but the homebuilders are trickier because they are consolidating their industry. That said, they own a lot of real estate, and would be hurt if land prices fall. They can be viewed as a bunch of land banks with development arms.

The Investor Base Becomes Momentum-Driven

If you remember one thing from this article, remember these summary comments on bubbles:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow's growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

This is what I see in many residential real estate markets now: panicked buyers are saying "this is my last chance," and are buying houses using risky forms of financing. At the same time, I read stories of despair as some potential buyers give up and say that a house is out of their reach for now; they waited too long. Occasionally, I see a few articles or e-mails regarding people (who seem to be bright) selling their homes and renting, but this is a minority behavior.

In the face of this, residential real estate prices continue to rise, particularly in the hot coastal markets, which tells me that the price momentum can continue for a little while longer until it fails. And it will fail because there is no incremental liquidity available to expand the local market bubblettes.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.