Oil, up or down?

Oil has been fluctuating around $70 a barrel US. Some would argue that oil is at an inflection point. In an article in Smart Money “Active Trader: Oil’s Moment of Truth?”, published August 28, 2009 by Elizabeth O’Brien, she states oil is at an inflection point. This means a dramatic change either up or down in the next month or two. Oil could go as high as $90 or as low as $55.

Most experts would argue fundamentals are weak with excess supply and lower demand. That being said, a number of factors impact the price of oil not withstanding the value of the dollar, supply and demand factors and geopolitical events. In addition, a recent study suggests that speculators now account for half of all traders in the main U.S. oil market. In the SFChronicle, David R. Baker wrote on Friday August 28, 2009 that seven years ago, speculators accounted for 20% of oil traders on the New York Mercantile exchange. That number jumped to 55% by the time oil prices reached the peak of $145 last year. The conclusion is that oil prices rose steadily with the price of oil. The study also warns that oil may be caught in a vicious cycle with the US dollar. Many investors fleeing a weakened dollar have put their money into oil, pushing up the price of oil.

When we look at a chart of XEG, an exchange traded fund which replicates the energy index on the S&P/TSX, the current price has been trading above the 50-day moving average since the beginning of March. Technically, the current price is consolidating at the 50 and 100-day moving average and it looks like the current price could cross the 50-day moving average to the downside. Volume traded is also getting lighter. Seasonally we are coming to an end for any short-term move up due to distributors buying supplies which typically stalls at this point.

Both the technicals and weak fundamentals give me reason to believe that the price could be headed down in the short run.

Buy low, sell high

Since the low in March, the Real Estate Investment Trust Index is up over 40% and it has outperformed the Canadian TSX/S&P index. My natural response is to ask why. All I can conclude is that is because it was beaten up so badly, dropping over 60% from its height in February of 2007. The question remains, is the economy recovering and everything else with it (real estate included)?

This week I am looking at the iShares CDN REIT Sector Index fund that replicates the performance of the S&P/ TSX Capped REIT Index. The index is comprised of securities of Canadian real estate investment trusts listed on the TSX. The top holdings include RIOCAN Real Estate Investment Trust (24.64%), H&R Real Estate Investment Units (14.83%), Canadian Real Estate Investment Trust (12.46%), Boardwalk Real Estate Investment Trust (10.15%) and Calloway Real Estate Investment Trust (7.53%).

The current price crossed the 50-day and 100-day moving average in April and crossed the 200-day moving average in early May. Relative strength and MACD are positive and volume is stronger than a year ago. From a technical perspective, all indicators are bullish, however, I am questioning what is driving the technicals.

Beyond the technicals, there are a number of considerations that you may want to take into account in your entry point into REITs.

There was an excellent article written in the CFA Magazine July-Aug 2009 edition titled The Outlook for Real Estate Funds written by Yves Courtois, CFA. He argues that Real estate and housing are generally sensitive to the direction of long term interest rates. Housing is typically counter-cyclical relative to stock markets because falling interest rates favour homebuilders in a weaker economy and rising interest rates undermine homebuilders in a growing economy. Homebuilders tend to be a leading indicator of the overall REIT market. He further argues that real estate is often an inflation hedge and “finding the dominant long-term trend in inflation or deflation, while filtering out seasonal counter-cyclical patterns, provides hints as to one of the fundamental drivers of real estate prices”. An 18-year cycle appears to be the most common. The last bust appeared in the early 1990’s. This begs the question as to whether we are at the start of a new cycle.

REITs operate a little differently than the broader real estate market in that they are typically made up of commercial properties that provide cash flow from leases so their valuations are based on property values and cash flow considerations. The types of properties include strip malls, like Safeway, apartment blocks or even health care facilities. Some important factors to consider in your analysis is the make-up of the properties within the REIT, when leases come due, leverage ratio and their payout ratio as a percentage of cash flow. Something Yves points out is that credit conditions are still tight and that a lot of leases are coming due, which could significantly impact REITs payout ratios if leases have to be renegotiated or tenants go out of business or choose to move elsewhere. A great deal depends on where we are at in this recession. He suggests an opportunity may be present in investing in funds targeting distressed properties. After all, the golden rule is “buy low, sell high”