Tuesday, January 03, 2006


TOA has a home in my portfolio

The market is off to a roaring start in 2006. While my portfolio wasn't quite able to match the stellar moves in today's major indicies, I still managed to gain about $5,300.

I picked up 700 shares of home builder Technical Olympic (TOA). While I do side with the prevailing view that the real estate market has topped, I am not in the camp that believes that there will be a major meltdown in housing prices (at least not for the foreseeable future), and given the cheap multiples at which home builders are currently trading, I think this is a good time to pick up a few shares of some of the more undervalued names, and TOA is close to the top of this list.

One of the things overlooked during the recent discussions about the inversion of the yield curve is the fact that this inversion may help the real estate market. Most mortgages in the United States are still contracted at fixed rates and hence are driven by movements in long-term rates, which have barely moved up as short-term rates have climbed. This is a plus for the housing market.

Of course, many mortgages, especially in the most speculative real estate markets, are floating rate and hence leveraged to short-term interest rates. However, what many people do not appreciate (or perhaps do not understand) is that an inverted yield curve implies that the bond market expects short-term rates to decline (otherwise one could earn unlimited profits from shorting long-term bonds and using the proceeds to purchase short-term bills, which pay higher interest). Thus, if the bond market is right and short-term rates decline over time, this will also help the housing market.

Still, housing stocks have been very volatile lately and while it looks like they have bottomed, I will be watching TOA closely. Although TOA has a home in my portfolio, I will try to make sure that it doesn't overstay its welcome.

An inverted curve TYPICALLY means that short term rates are expected to fall. This is based on behavior over the last 20-25 years.
It can also IMPLY that long term rates need to rise, particularly in a period of time prior to inflation or stagflation (as it occurred from 1977 through 1981).

While Short term rates eventually dropped, it was only AFTER they'd risen substantially AND long term rates had risen substantially.

Are we in a similar scenario? Probably not. But we're pretty close, and it's worth letting your readers know all the potential outcomes of an inverted curve.
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