The Carry Trade as Keyser Soze

"And like that he was gone. Underground. Nobody has ever seen him since. He becomes a myth, a spook story that criminals tell their kids at night. "Rat on your pop, and Keyser Soze will get you." And no-one ever really believes."

"Keaton always said, "I don't believe in God, but I'm afraid of him." Well I believe in God, and the only thing that scares me is Keyser Soze" - Verbal Kint in the Usual Suspects

One of my other favorite lines from the Usual Suspects was when Verbal Kint (Kevin Spacey) says that the "greatest trick the devil ever pulled" was convincing the world he didn't exist. Scientists, when they look at planets, never really see the distant ones, but they know they are there. How? They see distortions in the light coming from stars, a bend if you will, in the spectrum. Based on the distortion of the expected light, they can surmise that the planet is there.

And so you are asking yourself, what does this have to do with economics or real estate, or really anything? Well, like the light bending, showing the existence of a planet, just like the market bent showing the existence of the carry trade or maybe it was all just coincidence.

Timeline-

February 21st- The Bank of Japan raises interest rates 25 basis points to 0.5%
February 27th- Bottom falls out of DJIA 30, Nasdaq, S&P 500
March 2nd- Reuters states "Yen has best week in 14 months"

The carry trade is based on two bets, low Japanese interest rates, and a stable or falling yen. A rising yen, and higher rates destroy the motives behind the carry trade. The actions of the BOJ were obscured for a day or two by a falling yen. As the effect of the increase was beginning to be priced into the traders models, the trend reversed. A hiccup in the Chinese market, created an avalanche around the globe. Traders unwound positions in the US equity markets (sell sell sell) and bought Yen to pay off their loans in Japan. End result, equity markets down, the Yen up. Sure enough, exactly what we would predict happened, the yen strengthened, and equity markets were hit hard.

Fundamentals have now reasserted themselves, but beware the of the devil we can't see. As Verbal Kint, would say, "The greatest trick the devil ever pulled was convincing the world he didn't exist."

Demand vs Supply Side

Just a quick thought, as we were analyzing the Tucson apartment market this morning, it brought on a quick thought. Demand vs Supply. Basic economics right? Even, the non-econ will tell you economics is about supply and demand (they're not correct, but I digress) for changing definitions, see this post from Mike Mandel at Economics Unbound.

Well I think in the apartment industry, the big boys (Equity, Archstone, etc) have focused too much on the supply side of the equation. Their mantra has been "supply constrained" markets, aka high barrier-to-entry markets, places where it is hard to add additional supply. The other focus of which only one big boy (Camden) uses, is demand side. In the supply restricted areas (which incidentally aren't all that restricted, see the multifamily permit boom in SF, Oakland, and LA-all popular supply-constrained markets).

The biggest problem for the supply constrained markets, is their inherent volatility. In a study that I did, we identified the most volatile markets from a rental rate perspective and calculated a beta for them. San Francisco, San Jose, Oakland, New York, Boston were the top-5. The interesting finding from all this research is two things. Supply constrained markets are generally more volatile, and definitely more sensitive to economic conditions. This means that appropriate discount rate applied to these markets should be higher because of the greater degree of risk. Current valuation practices do not take this factor into account. In fact, over time, the high growth regions have generally outperformed (using real $2005) the so-called supply constrained areas.

In conclusion, the supply side focus is trendy, but wrong-headed and will leave certain big guys in the apartment industry with a bad hangover in a downturn. Yield management will help mitigate some of this effect, but that won't avoid the storm. It leaves companies like Camden, well placed to outperform its peers.