Debating the Flat Earth Society (Part 1)

One of the rules that scientists try and follow is to not debate the flat earth society. It simply lends credence to the idea that there is actually something to debate. For the same reason scientists will not debate creationism vs. evolution either.

Occasionally, however, a flat earth society theory actually manages to come into popular belief. This is one of those times. Right now there is a widely held belief in “goldilocks” and that corporate spending and construction will somehow pick up the slack where consumer spending and retail construction left off. Goldilocks is of course a fairy tale but to be fair, I did volunteer to rebut the goldilocks theory as presented on the Salt Lake Real Estate Blog .

This debate came about when I informally responded to the above link on Silicon Investor. Salt Lake (SL) then sent out a “challenge” along with a rebuttal to my brief responses. I was busy and failed to respond to the rebuttal in the required time. Shortly afterwards SL proclaimed victory. That notion will be put to rest now as we look at the main data points of his arguments (corporate balance sheets, real estate appreciation, building costs, and rents).

The amount of material supporting the notion that corporate real estate expansion is NOT about to pick up where residential real estate left of is massive. It was so massive that I had to break this rebuttal in half and each half is still lengthy. That of course is one of the reasons for the delay in responding. During the delay, additional supporting evidence came in further increasing the length.

Part 1 of my response will discuss Corporate Balance Sheets and Real Estate Appreciation.

Part 2 of my response will discuss Building Costs and Rents.

Corporate Balance Sheets

SL: Corporate balance sheets are flush with cash. Companies have been reluctant to spend much since 911. You stock guys know this.

Mish: They have been wasting it on stock buybacks, mergers etc. There is no need to expand because there is overcapacity everywhere.

SL: And there’s no denying record levels of cash on corporate balance sheets, or the tendency of the increasingly generous buybacks to force the stock market higher.

With all that cash on the books, companies are looking to invest it in places that will yield high returns. Their choice is in stock buybacks and merger opportunities because they are a good investment right now. The New York Times said, ” management says it is buying back shares because they are bargains.”

Companies are also expanding building. I’ll deal with the particulars in the next section because it will be more germane there.

Mish: Exactly what do mergers or buybacks or forcing shares higher have to do with expansion of commercial real estate? The answer is nothing. Exactly what do share prices supposedly being a bargain have to do with expansion either? The rebuttal is pure silliness and besides share prices are far from being cheap. If share prices were cheap corporate insiders would be buying shares not unloading shares at a record pace as they are doing now. Please consider Top-Level Insiders Selling Their Stock.

December 7, 2006 — America’s corporate chiefs are unloading their own stocks at one of the boldest paces in 20 years. In cases of the very rich, such as Microsoft’s Bill Gates and Google’s top brass, the executives are selling a whopping $63 for each $1 of stock they bought, says a report by Bloomberg. In November alone, leaders of public companies dumped $8.4 billion worth of stock they owned as insiders, most of it awarded as compensation, bonuses or other management incentives. Analysts say a take-the-money-and-run flight from their own companies signals a growing lack of confidence in the economy’s future course.

Simply put if executives thought their stocks were cheap they would not be bailing at the fastest rate in 20 years. If they thought the future was promising their corporations would not be buying back shares but expanding their businesses. Stock buybacks suggest companies can not expand profitably so they buy back shares instead. Mergers typically result in duplication of services and that leads to firings not hirings.

Lets also look at leveraged buyouts. I discussed this aspect in Changing Priorities.

Casino giant Harrah’s Entertainment Inc.’s debt load will nearly double and its priority will shift to paying it down instead of reinvesting in growth after one of the biggest leveraged buyouts ever, according to SEC documents filed Wednesday.

Harrah’s historical priorities show two check marks beside “reinvest for growth” and “mergers and acquisitions,” but only one beside “share repurchases” and “reduce debt.” Under the new structure, only one check mark goes toward reinvestment and acquisitions, while two appear beside reducing debt.

While on the subject of corporate balance sheets please consider Remarks by John C. Dugan Comptroller of the Currency on systemic risks to the financial system.

Also note that 2.2 Million Subprime Borrowers Face Foreclosure according to the Center for Responsible Lending. 2.2 million foreclosures will add to pent up supply would it not? Of course there is theory and there is practice. Let’s look at some actual data. Foreclosure activity surges in Massachusetts (up 300% from last year) . How about Georgia foreclosures jump 99%; rate is nation’s 3rd highest .

What about Colorado Foreclosures?

Last month, 5,051 homes in Colorado — one new filing for every 362 households — entered some stage of foreclosure, up 88 percent from November 2005. “It’s sort of the tip of the iceberg, and the problems are going to get worse before they will get better,” U.S. Bank regional economist Tucker Hart Adams said. “I think we will see housing prices declining, sales down and new construction down for another year,” Adams said.

I also see that California foreclosures surge 171 percent in Q3.

  • National foreclosures increase 43 percent
  • Colorado, Nevada and Florida have highest rates

More than 37,000 homes went into the foreclosure process in California in the third quarter, a 171 percent increase over the same period in 2005, according to RealtyTrac, an Irvine-based foreclosure information company.

The California number was up 35 percent from the second quarter of 2006.

Nationally, 318,355 properties entered some stage of foreclosure during the third quarter of 2006, a 17 percent increase from the previous quarter and a 43 percent yearly increase from the third quarter of 2005.

The nation had a foreclosure rate of one foreclosure filing for every 363 households during the quarter.

Those are massive rises in foreclosures that can no longer be blamed on Hurricane Katrina or changes in bankruptcy laws. Flat earthers will no doubt state that the rise is coming from a low level. Yes it is, but the rate of growth is staggering , GDP is slowing , and $1 trillion in mortgages are going to be reset in 2007. Those foreclosures pose a systemic risk to the financial sector.

Short Summary

  • Stocks are not cheap as proven by insiders’ actions as opposed to their words.
  • Stock buybacks happen when corporations have no better place to put their cash (expansion makes little sense).
  • Mergers tend to lead to job cutbacks because of corporate duplication.
  • Leveraged buyouts result in changing priorities from expansion to debt paybacks.
  • 2.2 million households face foreclosure and foreclosures will add to supply.
  • Actual data confirms massive increases in foreclosures on a national basis.

Foreclosures pose a systemic risk to corporate balance sheets — especially with lending institutions.

Commercial Real Estate Has Appreciated

SL: Commercial real estate holdings have increased in value. Appreciation has hit the commercial side as well. This is partially responsible for the better balance sheets.

Mish: So a bubble in real estate assets is going to cause them to expand more? For how long?

SL: Appreciation in real estate is causing increased profits, both in stock value and cash position. MSN Money reported last year:

Find companies with a lot of real estate on their books at rock-bottom prices because they bought it long ago. As these companies sell or develop that land and realize its value, shareholders should see big payoffs.

This has held true for other companies such as those in retail that have had real estate positions for many years as a function of doing business.

Companies are expanding as well. The NAR reported last month, “Commercial real estate sectors are on solid ground with generally tightening vacancy rates and sound fundamentals.”

Architecture firms confirm this data: A monthly index of billings by architecture firms points to continued strength in U.S. nonresidential construction for the next nine to 12 months.

The index, which predicts construction spending up to a year ahead, has pointed to continued growth for four consecutive months, and suggests a healthy outlook throughout 2007, the AIA said. All regions except the U.S. Northeast saw growth in construction activity.

Mish: The argument that because commercial real estate has appreciated will lead to more expansion is complete silliness. So is the notion of shareholder profits. Businesses expand when they have legitimate reasons for expansions, not just because the value of their real estate went up or profits went up. As discussed in Corporate Balance Sheets (above) those arguments are simply without merit. You are essentially presenting the same argument twice, and it makes no more sense the second time as it did the first.

Quoting the NAR “The Voice for Real Estate ” as proof of the strength of real estate is the equivalent of asking the guy in the red suit and white beard at the shopping mall during Christmas season if he believes in Santa Claus. Of course he will say he believes in Santa Claus.

As for the AIA you actually presented your first valid argument. Indeed I see a Six Point Surge in Architecture Billings Index.

After consecutive months of very modest growth, the Architecture Billings Index (ABI) saw a considerable jump in November to its second highest reading of the year. The commercial / industrial sector recorded its best mark of the decade and while still reporting weak billings, residential architecture firms showed encouraging signs by posting the highest score in four months.

Key November ABI Highlights

  • Regional averages: West (60.7), Northeast (58.0), South (51.1), Midwest (49.5)
  • Sector index breakdown: commercial / industrial (62.9), institutional (54.6), mixed (50.6), residential (47.4)

I am not sure what to make of slight contraction in the Midwest, slight growth in the South, and decent growth in the West and Northeast. The questions here are several.

  1. Was this an outlier?
  2. What timeframe are we talking about?
  3. Will this really pick up where residential left off?

Question 1 simply can not be answered until we see next couple month’s numbers.

Question 2 was not discussed (unfortunately) but I presume to mean to be for the downturn cycle which I believe is in the early innings.

Question 3 is best answered by looking at past history of real estate busts, recessions, and time lags between residential real estate growth and non-residential real estate growth.

Attempting to address question 3, I point to Calculated Risk’s analysis in Housing: Starts and Completions

Based on historical correlations, it is reasonable to expect Completions and residential construction employment to follow Starts “off the cliff”. This would indicate the loss of 400K to 600K residential construction employment jobs over the next 6 months.

Here is additional analysis by Calculated Risk that suggests that nonresidential construction historically follows residential construction. Please consider Has Nonresidential Construction Peaked?

Historically nonresidential investment (including nonresidential construction) has trailed residential investment by about 3 to 5 quarters. Since residential construction spending peaked in December 2005, and residential construction employment peaked in February 2006, it is about time for nonresidential construction to peak – if spending and employment follow the common historical patterns.

Once again the above link provides interesting charts and commentary suggesting the hit on commercial real estate is in front of us not behind us. Logical thinking would suggest why this is s As subdivisions are built, services (grocery stores, strip malls, Home Depots, restaurants, etc follow with a lag). So as residential construction winds down, commercial construction remains strong for possibly as long as 5-6 quarters. It will be the unwinding of commercial real estate that will provide the next leg down in real estate. Yes, that is supposition but it based on historical trends backed by logic as opposed to cheerleading by the NAR.

Enquiring minds might be asking if there is any hard data to support this conclusion.

Indeed there is. In November Jobs Report I provided the following chart and analysis.

Following is a chart of construction jobs (both residential and non-residential) for November 2006.

Before discussing construction please note the red vertical oval. It shows that 40,000 goods producing jobs were lost. It also shows that of the 132,000 jobs that were created, 13.6% (18,000) jobs were government jobs. The last thing we need is more unproductive government jobs. Taking those two numbers into consideration, this was a fairly weak set of jobs numbers and supportive of the idea we are in an economic slowdown. The massively inverted yield curve also suggests that not only is a slowdown coming, but an out and out recession is coming.

It is simply illogical to assume that businesses would even want to keep expanding in the face of a consumer led recession. Even if they did, it is important to remember that consumer spending is 70-75% of the economy (and possibly higher in THIS economy). With that as a backdrop it is also illogical to expect that corporate spending can possibly pick up the slack even IF businesses were to keep expanding in the face of a consumer slowdown.

Nonresidential building has now shown a 4 month steady decline in jobs even as non-residential trade jobs are holding up over the same 4 month period. This divergence between trade jobs and building jobs is unlikely to hold. With an October to November decline in non-construction trade jobs it is possible that this divergence is now being resolved but we must wait and see if the data point on trade jobs is an outlier.

What we can see for sure is that huge cracks are starting to appear in the myth that “corporate expansion is likely to pick up where consumer spending left off”. In the dotcom bust of 2000 strength in consumer spending did pick up when corporate spending was slashed, but it is simply illogical to expect the opposite to be possible.

When corporate expansion does crack it will be part of a “Second Wave Down” in construction and jobs and will have a far greater economic impact than the decline so far in residential construction.

Finally I would like anyone to address the following challenge that I made in Bernanke’s Box when I asked…..

Can someone please tell me what we need more of?

Home Depots?
Pizza Huts?
Restaurants of any kind?
Strip Malls?
Furniture Stores?
Nail Salons?
Office Supply Stores?
Grocery Stores?
Appliance Stores?
Auto Dealers?
What? What? What?

We need more of nothing — that’s what. There is a veritable glut of every kind of store imaginable. The construction of all those places provided jobs. The staffing of all those stores provided jobs.

The bottom line is there is simply no need for businesses to expand into a consumer slowdown. It would not make economic sense to do so and that is arguably why corporate insiders are bailing at a record pace, even as stock buybacks continue unabated.

Given that overcapacity is a theory let’s take a look at how some real companies are actually doing in practice.

Black & Decker Lowers Profit Forecasts on Sales Drop.

Dec. 15 (Bloomberg) — Black & Decker Corp., the second- biggest U.S. maker of power tools, cut its fourth-quarter forecast because of “significantly’ lower sales in the U.S. Fourth-quarter sales will probably decline 8 percent because of a slowing U.S. housing market and falling demand for goods such as power saws. Stanley Works, the biggest U.S. toolmaker, cut its sales forecast October 24.

YRC Worldwide Updates Earnings Guidance [YRC is a trucking company]

“As widely reported by industry analysts, the economy has slowed significantly in the fourth quarter, resulting in lower volumes than we anticipated across all of our asset-based business units,” stated Bill Zollars, Chairman, President and CEO of YRC Worldwide. “As a result of this economic slowdown, we are adjusting our earnings guidance.”

“While the extent of the economic slowdown is uncertain, our business units are aggressively managing costs to create the best possible results for our shareholders,” stated Zollars.

Herb Greenberg mentions YRC and the markets in general and asks Is it brains or a bull market?

In Bernanke’s Box I also noted Home Depot Sales Falloff Kills Staff Increase Plan.

November 30, 2006 — Home Depot abruptly shelved a much-touted plan to improve customer service by hiring more store-level employees – just a month after rolling it out. The about-face appears to be the result of a sales slowdown that is far more severe than the company anticipated, sources said. Rather than hiring additional employees, all stores – even those $40-million-plus high-volume locations – were told to cut staff hours by 200 per week because of falling sales.

The reason? Sales were falling short of internal projections, the result of a housing market that had stopped booming.

For Home Depot to go from hiring plans to firing plans in a single month, things must have gone to hell in a handbasket in a hurry. There is no other rational explanation.

I see that Circuit City Swings to Loss in 3Q.

Consumer electronics retailer Circuit City Stores Inc. said Tuesday it swung to a loss in the third quarter as deep discounts on flat-panel televisions and computer hardware and software cut into profit margins. It also lowered its full-year sales outlook and shares fell more than 16 percent.

The nation’s second biggest consumer electronics chain after Best Buy Co. Inc. reported a loss of $16 million, or 9 cents per share, in the three months ended Nov. 30. Analysts polled by Thomson Financial were looking for a profit of 5 cents per share.

Hmmm does that report say both Best Buy and Circuit City reported losses? Indeed it does. Is that too much competition for too few customers with too little demand? Yes again. Is that a sign of overcapacity? Why yes it is. Would it be rational for such businesses to go on an expansion binge? Of course not.

We talked about YRC, but inquiring minds might be wondering about UPS. I see that More Job Cuts Planned At UPS:

December 13, 2006 ATLANTA — UPS Inc., the world’s largest shipping carrier, is seeking more job cuts on top of 1,200 positions in its logistics unit that it previously said it would cut.

The Atlanta-based company has offered voluntary severance packages to about 650 employees at its headquarters and in its Supply Chain Solutions division in the United States.

Since when do shipping companies announce layoffs at Christmas, typically the busiest time of the year? UPS and YRC suggest huge problems and Circuit City, Best Buy, and Walmart confirm the overcapacity problems in retail.

Commercial construction tends to lags residential construction simply because Wal-Mart, Pizza Hut, Home Depot, Nail Salons, Best Buy, etc., finish their buildout after residential areas are built. This is only logical, but the mantra being sung by Wall Street pundits is that somehow corporate spending will save the day.


  • Commercial Real estate appreciation is not a logical argument for expansion.
  • Corporate profits are not an argument for expansion when insiders are bailing like mad.
  • Wishful thinking by the NAR is laughable.
  • The diffusion index by the AIA is a valid point.
  • Non-residential building jobs are down.
  • Commercial real estate tends to follow residential real estate with a lag.
  • UPS and YRC suggest huge falloff in shipping demand.
  • Circuit City, Best Buy, and Home Depot confirm the overcapacity problems in retail.
  • Over capacity is stunning. We simply do not need more stores and profit margins are clearly being squeezed.

This concludes Part 1 of Debating the Flat Earth Society.

Mike Shedlock ~ “Mish”
December 26, 2006