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Good morning. Jay Powell expressed a slightly more hawkish stance in his appearance before the House yesterday, causing tech stocks to waver. But the most important revelation was that the Federal Reserve chair has been a fan of the Grateful Dead for the past 50 years. So, the question remains: which Dead song best represents the Powell era in monetary policy? Currently, “Don’t Ease Me In” seems most fitting. Feel free to email us at [email protected] and [email protected].
That Impressive Housing Starts Number
It has become somewhat of a Wall Street cliche to say that the business cycle is driven by housing. However, this wasn’t always the case. Edward Leamer’s 2007 paper, “Housing IS the Business Cycle,” crystallized this commonly held belief. Leamer argued that “housing starts and the change in housing starts… together form the best forward-looking indicator of the cycle.” While residential investment isn’t usually a major contributor to GDP growth, it plays a significant role in the sharp changes in growth that occur during recessions and recoveries. This is particularly true during the period leading up to a recession when demand softens and house prices remain stagnant (as we have recently witnessed).
Some argue that housing is less influential in the cycle now compared to when Leamer wrote his paper, but the basic premise still holds true. Therefore, there was some excitement when housing starts experienced an impressive 22% increase between April and May. This significant jump was highlighted in recent discussions about whether the Federal Reserve should continue raising rates. If this surge in housing starts reflects homebuilders’ confidence in demand (which seems likely given strong readings from homebuilder surveys), it contradicts our previous argument that home prices are currently experiencing a “false spring.” However, it’s important to differentiate between the new-house market and the housing market as a whole. We at Unhedged have been contemplating this distinction extensively over the past few months, particularly because of our regrettable decision to short a homebuilder in this year’s Financial Times stockpicking contest. We believed higher rates and an economic slowdown would negatively affect homebuilders. Instead, higher rates froze the existing home market and redirected a significant portion of demand to the smaller new house market where some inventory is available. Admittedly, this outcome was predictable, and we feel foolish for not anticipating it.
That being said, the surge in housing starts in May hasn’t compelled us to reevaluate our generally pessimistic view of the overall housing market or our belief that a recession is on the horizon. Here’s why:
It’s just one month of data.
Purchase mortgage applications, which offer a better gauge of the overall market, continue to remain at levels reminiscent of the financial crash.
While new home sales volumes are strong, it’s important to consider the role price cuts play in this success. In April, new home prices were 15% below their peak levels in October (according to the Census Bureau). This represents a significant drop, as the peak-to-trough decline in new house prices during the financial crisis was 22%.
There are probably many individuals who have a better track record in predicting housing market trends than us. If you happen to be one of them, please feel free to email us.
Google: The Insignificance of Antitrust
Gannett, a major US publisher, filed a lawsuit against Google on Tuesday, alleging that the tech giant has engaged in a sophisticated, anti-competitive, and deceptive scheme for over a decade. This lawsuit follows previous antitrust accusations against Google in recent years. Gannett argues that Google’s manipulation of major demand and supply conduits for digital display ad auctions, as well as its control over the primary exchange where buyers and sellers interact, creates incentives for the company to steer publishers and advertisers in its desired direction. Gannett claims that Google has prohibited publishers from seeking competitive bids from rival exchanges while using inside information from its publisher platform (DFP) to rig bids on AdX (Google’s exchange). For example, Google forbids publishers from sharing reader data with rival exchanges, leading to substantially lower bids from these exchanges. AdX then takes advantage of these depressed bids by returning bids that are just a penny higher, despite originally receiving higher bids from AdX buyers for the same ad slot. As a result, Google earns significant profits from manipulating ad space auctions. In 2022 alone, the company made $30 billion from these practices.
This argument, which accuses Google of self-dealing, has gained significant momentum and is currently being presented in court by the US Department of Justice and the European Commission. However, the impact on Google parent company Alphabet’s investors is relatively insignificant. Display ads account for only 10-12% of Alphabet’s total revenue, a similar share to that of YouTube and Google’s growing cloud business. Search ads are the real money-maker, generating roughly 60% of Alphabet’s revenues. While a forced change in the way Google offers display ad services (e.g., through divestiture) could have some negative effects, it wouldn’t be particularly damaging.
In fact, the stakes may be even lower than initially estimated. Brian Macauley, portfolio manager of the low-turnover Hennessy Focus Fund and an investor in Alphabet, pointed out that display ads represent a low-double-digit percentage of revenue and have a lower profit margin compared to the search-engine business. Consequently, display ads account for less than 10% of profits. Furthermore, the growth rate of the display ad business is slower than that of the rest of Alphabet. Even if the legal proceedings surrounding Google’s display ad practices take years to conclude, Macauley believes that it will eventually amount to less than 5% of Alphabet’s operating profits. Ultimately, the display ad business’ contributions to Alphabet’s overall performance may be considered “non-material.”
From a bigger perspective, Alphabet’s stock resilience stems from its dominant position within a secular growth market. Digital ads have experienced explosive growth for years, and although this growth has slowed down slightly, it is still projected to increase by approximately 10% annually until 2026. Additionally, Google’s position as the market leader appears unchallenged. According to Macauley, the biggest concern for Alphabet investors is the potential increase in cyclicality as the overall digital ad market matures. If investors have to deal with more volatile revenues, it could lead to a reduction in the company’s multiple, which currently stands at 26 times trailing earnings. However, this change will be determined by market forces and not the outcome of any legal proceedings.
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