Basics: Impact of lagged, moving averages (Aug CS)

While the headlines for this month’s release of the Case-Shiller indices look positive, many who follow this market know that the index does not reflect today’s (8/31/2010) sentiment, but measures a 3-month window, that is lagged two months.

As the illustration indicates, today’s numbers measure the results of home prices from April through June.   Note that today’s index is primarily the result of dropping the March numbers (that were part of the May series -released in July), while adding the June numbers.  As such, one of the key parameters for month to month comparisons on the current index is the difference between the March and June single month numbers.

The formulas involved are not simple averages of the three months -hence, why I show index weights (w1, w2…) for each month.   As such solving for each month’s precise value is impossible (six variables for each month’s equation), but one can strongly infer that a reason the Boston contract rose from 155.95 to 157.83 was a large (~5point) difference between March and June single month values.  (Possibly a result of seasonals and the pending expiration of the tax credit program).

This feature of the CS index calculation allows for some averages to rise, even when sentiment has turned negative.   As such, you get situations such as this month where the actual NYM and CHI indices were higher than where CME contracts were offered yesterday (when trading expired).  (See table).   As bid-asked spreads in the current month averaged 3.5 points across all contracts at expiration, this kind of trading opportunity will likely to continue to exist when sentiment changes are not aligned with index math.

(BTW-Hat’s off to Radar Logic for “calling” the CUS quote.  They had predicted that the index would be 161 in a press statement pre-#’s).

So with the index trending one direction, and sentiment the other, where do we go from here? 

First the good news.  With the expiration of the August contract open interest declined by only 6 contracts.  We next face a November expiration (which has historically had the biggest open interest) to be followed by the Feb. ’11 contract which people should focus on for year-on-year comparisons versus 2010 home price predictions.  So, lots of people who should care.

Next the bad news (or good if you like volatility).  With the divergence between index calculations and sentiment, I would expect bid-asked spreads for near contracts to be wider than they’ve recently been.  As Professor Shiller noted on today’s S&P call, prices might revert to their historical long-term upward trend, or they could revert to the strong downward leg that was interrupted by the housing stimulus plan.  Timing on the (well touted, upcoming) downward turn in home prices will be critical to trading Nov ’10 and Feb ’11 contracts.

“Be careful out there”