What is "Inventory"?

At "A Dash" we are interested in how current commentators make a facile link between micro and macro-economics.

The problem is that they think micro, and speak macro.

Micro helps with the supply curve.  And the demand curve.  Where do they intersect?

Honeymoon in Vegas:  Inventory?

Getting away from traditional thinking is difficult.  Sometimes it helps to start with an outrageous example.  My nomination is Sarah Jessica Parker in the movie, Honeymoon in Vegas.  This movie is a lot of fun -- well worth the DVD rental.  The basic plot is that a guy wins $65K in a poker game (contrived) with another guy and agrees to cancel the debt for the creditor's weekend with his fiancee.

Simply put, she was not "in inventory" before this offer.  But everything has a price -- maybe.  Roger Ebert is our go-to guy on movies and he gave this one 3 1/2 stars.

The point?  There is always "inventory away from the market."

Application to Stocks

There is "inventory" of any stock.  Let's take Apple, Inc. (AAPL) as an example.  It is a stock which we own for both individual accounts and institutions. Let us suppose that our fair value for Apple is 220.  We would be sellers if that level were approached, and buyers at a lower level.  We have a wide market.  Other Apple investors have different markets.  Each day's trading reflects the current market for the stock.

The individual demand and supply curves are a function of microeconomics.  The intersection of the curves is a macro phenomenon.  To understand stocks means knowing both.

Application to Housing

The current discussion of housing seems to confuse the micro and macro.  There is much attention paid to housing that is "in inventory."  Today's report on home sales and prices provided the information that there is currently a 10.6 month supply, arrived at by taking homes offered for sale and dividing by the current annual rate of sales.

The consensus interpretation of these data is that these homes will remain on the market until sellers get more realistic about pricing.

Errors in this Approach

The standard approach to the housing market has two conceptual errors.  Let us illustrate this by looking at our own neighborhood, consisting of four-bedroom homes with family rooms, fireplaces, large master suites, dens, and a community geared toward safety for kids and good schools.

As children get older and leave for college, the empty nesters offer their homes for sale.  They have a price in mind, but they are not forced sellers.  They may be thinking of buying a retirement condo at a similar price.  There are other sellers who have new jobs in another community.  They are more motivated sellers.

Let us suppose that homes are selling at a price of $500 K.

The inventory errors are twofold and conflicting:

1. It understates inventory "away from the market."  Some (non-motivated) sellers have offers at $550 K.  These homes are not trading.  If prices approached this level, there would be a lot more inventory!  Many people who know that the price is unrealistic have not listed their homes, but would do so if prices moved higher.  This suggests that the  quoted "inventory" figures are understated.
2. The analysis assumes static demand.  The measurement of inventory depends upon the current rate of sales.  Anything that influences demand would dramatically change the months of supply.  The demand curve would respond to several factors, including a perceived stabilization in pricing, strong government programs to aid buyers, or improved availability of mortgages. There may be buyers at current prices if conditions changed -- a shift in the demand curve.

Analysis

Many observers have noted that potential buyers are concerned about falling prices.  They fear that buying now will leave them under water in a few months.  These people are qualified buyers who are not willing to "pull the trigger" until they see stability.

The demand picture is also influenced by the limitations on available loans.  Any moves to increase lending power -- more capital for lenders or a resumption of securitization -- will shift the demand curve.

Higher prices will bring out more sellers.  There may be much more inventory at higher prices -- inventory not reflected in current listings.

Conclusion

The typical analysis one sees in the financial media takes a superficial approach.  It assumes that all inventory is "real" and does not consider either "latent supply" at higher prices nor "latent demand" at current or lower prices.

Investors interested in housing problems -- and we all should be -- must consider how both supply and demand curves will change in a dynamic environment.  Looking only at the apparent supply, and assuming that sellers will eventually reduce price offers, is a mistake.

We are not selling Apple at 185....

Any analyst not looking at both supply and demand curves, and potential shifts, is not giving a complete picture. 

Comments

[Global Supply Chain Management]

Lol, using Sarah Jessica Parker to describe inventory...I love it!

[elgraccho]

Lord

>Averages have little utility in real estate other than to identify which areas will exceed them and which will fall behind.

I can accept this if you're willing to change your tense from future (will exceed/will fall) to present perfect (have exceeded/have fallen). The differing extrapolations folks make from the past into the future are (to mix a metaphor) what horse races are made of.

Of course, it's all about estimating the degree of risk you're willing to tolerate and pricing accordingly. If I'm reading you correctly, you might accept negative current cash flow in anticipation that the value of the underlying asset would rise, or that rents would (soon?) increase to the point that your cash flow would no longer be negative. Of course, if rents increase dramatically, the price of the asset will follow.

This would leave you underwater each month until you realized the appreciation by selling the property or had the pricing power to increase the rents above zero cash flow. You might well win your bet. On the other hand you might be buying into Las Vegas in 2006, or Houston in 1980, or Wink, Texas (boyhood home of Roy Orbison), in 1927.

It occurs to me that stating a specific ratio was an error on my part. The 10x I chose was based on today's cost of money. The underlying point I was trying to make was that I'd insist on positive cash flow from day one. Obviously, I'm not cut out to be a real estate gunslinger.

Best wishes.
elgraccho

[Lord]

If supply were indefinitely expandable this might have some validity, but it is not. In large metro areas supply is heavily constrained often requiring land use changes that are difficult or impossible to make. Real estate is local and every property unique. Averages have little utility in real estate other than to identify which areas will exceed them and which will fall behind.

[elgraccho]

>This would only be true if growth were constant across locations, which is not true by a long shot. Growing locations have greater returns which support higher prices and lower relative rents since gains are inherent.

Accepting negative cash flow in return for an assumed increase of value of the underlying asset is a fairly good description of how we got into the current real estate mess in the first place.

I take it that what you call growth is an increase in demand (in the current case, probably caused by an influx of population). So long as supply remains relatively constant, prices (rents) must, of course, inevitably increase.

But, while supply will initially lag as demand pressures begin to build, eventually it will catch up with, and perhaps exeed, demand. When this occurs, the enhanced 'multiple' is no longer justified. In fact, rents will likely decline because of the supply glut.

I'd argue that in high growth areas where supply is lagging, rents will increase. This will cause prices to increase with no change in the multiple. Those who accept a higher multiple (negative cash flow) are betting on a continuing increase on upward pressure in real rents, which must eventually tend toward the parabolic. And we know how parabolic price curves eventually resolve, yes?

[Lord]

> And the 'multiple' is probably more or less constant across good and bad locations: what changes is the rental income that an otherwise identical property could generate.

This would only be true if growth were constant across locations, which is not true by a long shot. Growing locations have greater returns which support higher prices and lower relative rents since gains are inherent.

[RB]

Let's say that we are Fed model believers and the overall stock market had a PE of 50 while interest rates were 5%. Then, let's say that interest rates fell by 50% to 2.5% while stocks PE went up only by 20% to 60 instead of going to 100. Hooray, stocks are cheap per the incremental Fed model. I think that's what our dear friend Sebastian is saying up there with his buy now or forever get priced out story. Let's call it the incremental affordability model. (Sounds suspiciously like the Sebastian at CR).

[elgraccho]

As I recall, "demand" and "wishful wanting" aren't synonyms. Demand can only exist if the buyer actually has the wherewithal to make the purchase. If I only have $100, I can't be part of the demand for a share of AAPL at $200, unless I can finagle my broker into opening a margin account based on my paltry c-note. Not bloody likely, eh?

Most of the folks blogging and commenting thereon are far enough up the economic food chain that this isn't an issue. But the guy (doll?) who can't come up with the scratch to get into the game (a local relitter recently told me that standards had been 'tightened' to require a whopping 3% down), can't be part of the demand.

Similarly, those underwater on their starter homes can't be part of the demand for 'move-up' properties (like the one I've been trying to sell for the last nine months), since they no longer have any equity for the trade-up.

Even those with positive equity in their starter homes find themselves competing, as you noted, with the REO overhang (there's very little new construction in my corner of Olde Niewe Englande), as well as with the burgeoning short sales market.

These two are absorbing much of the demand at the lower price points in my area.

For the time being, the spiral is all downward.

Unlike AAPL, however, housing has real utility--you can live in it. Because of this, we can measure what it's really worth by observing rents paid for similar accommodations.

If you accept a 10x factor for Price/Yearly Rental, the objective answer is that sales should take place at about 35% below average asking prices around here. Factoring in the intangibles (pride of ownership, blah, blah, blah), the expectation might be for further declines in the 20-25% range. (If you think you could generate positive cash flow at a lower level, maybe you'd prefer to substitute 12x for 10x).

And the 'multiple' is probably more or less constant across good and bad locations: what changes is the rental income that an otherwise identical property could generate.

[Sebastian]

"The analysis assumes static demand. The measurement of inventory depends upon the current rate of sales. Anything that influences demand would dramatically change the months of supply. The demand curve would respond to several factors, including a perceived stabilization in pricing, strong government programs to aid buyers, or improved availability of mortgages."

This is dead-on. There's zero mention in the housing blogosphere of demand or the kinds of things that could suddenly drive it up.

I got monthly new home median sales prices (Census Bureau) and monthly conventional mortgage rates (Federal Reserve), then calculated monthly mortgage payments (PI only) assuming 20% down.

From June 2003, with a mortgage payment at $828.21/month, it rose 57% by April 2006 to $1300.88/month. Home prices, however, "only" rose by 37% during the same time-period. Interest rates were rising while this was going on.

My point: Interest rates are low now and relatively steady, so there's no particular rush for potential home buyers to get in. If mortgage rates begin to rise, though, driving up the monthly payment, that's the kind of thing that would get them off the dime and home sales would pick up. Buyers aren't looking at the price of the house, but their monthly payment, and if it looks like it's going to get more expensive...

Sebastian

[Lord]

I doubt anyone seriously thinks a 10 month inventory means in 10 months there won't be any so I don't see these as misleading in any serious way, though sales are the more important number. I don't see many desperate lenders out there so prices and volume seem to have hit resistance recently.

[Michael F. Martin]

Jeff,

This is a great post. I've been working for the last few weeks to rebuild supply and demand from scratch with a more dynamic model, and yesterday I think I managed to do it:

You can reconstruct aggregate supply and demand from frequency distributions that apply to particular activities. For example, if you know that people, on average, eat 3 times / day, then you can reconstruct the demand curve for a population. Similarly, if you know how long it takes to cook meals on average, you can reconstruct the supply curve for a population.

The fundamental point is that neither economics nor accounting includes models or measurements of the frequency (i.e., how often) economic events occur.

The last four posts on my blog have more. brokensymmetry.typepad.com

[SI]

Actually there is some inventory that is well-defined -
(1) all the new homes being built and must be sold because any given builder cannot live in 10 homes simultaneously, and
(2) bank owned / foreclosed houses.
Both of these point to severe oversupply.

The concept of inventory makes no sense for currently occupied houses. Nor does it make sense for motivated sellers - some of them may just choose to become landlords.

The long term buy&holders (=current homeowners) may not sell, but some people have to sell their AAPL - for instance, employees who get paid in stock grants and don't care particularly about the direction of future price. (= the home builders.) And if you own LEH and AAPL in a margin account, your AAPL might just... get foreclosed on, oops sold in a margin transaction.

[Mike W]

I agree with Mista B.

Although you are pointing out truth (that even more inventory exists at a higher price point and more demand exists at a lower price point) the market can only be transacted when seller agrees to buyer's price or buyer agrees to seller's price.

You're sorta leaving out the market psychology. When everybody had to get into a house or be priced out forever, and others found their home values doubled in a few years, you had a seller's market, and buyers were happy to get into the party.

Now that the emperor has been discovered to be naked, and people are generally mistrusting of tailors, we're heading into a buyer's market where prices will have to be a no-brainer in order for buyers to participate.

As an eventual first-time buyer who kicks himself for missing the last housing bust. I can assure you I will not miss this one. At the same time, it doesn't make sense to jump in as prices continue to fall (until again prices reach some sort of fair market value).

When foreclosures come under control I'll know it's time to buy.

[Mista B]

Not really sure what you're getting at with this article. No matter which way you slice it, there are a ton of homes for sale and very few buyers. Prices are lower than they were last year. There are more homes listed. And there are still far fewer sales. The latent supply issue at higher prices is practically a fantasy (not that it's untrue). We're unlikely to see higher prices anytime soon. The latent demand is reality. At some price, virtually every house is worth it. Until that price is hit, though, it won't get sold. This is history in motion. Just wait until the UK and Australian bubbles burst. They're just starting to.

It's funny in a way. First there was no bubble. Then we were going to have a soft landing. Then subprime was contained. Now the worst of the credit crisis is behind us. This is what is typically heard from the powers that be and the pumper crowd. Nevertheless, there are numerous bloggers who've been vindicated in the accuracy of their predictions.