| Are Homebuilders the Tail Wagging the Dog? |
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| Written by Matt Blackman | |
| Sunday, 04 May 2008 | |
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Are homebuilders the tail wagging this dog-gone market? And if so, what does it mean for stocks? Few would argue with the contention that housing markets look bleak. Last week we learned that existing home sales fell another 2% in March and are down 20% in the last year. And according to the rather unreliable median home price data courtesy of the National Association of Realtors, prices across the country are down 7.7% from March 2007 but this number minimizes the actual decline. On Tuesday we learned that the February Case-Shiller Home Price Index dropped to its lowest level since November 2004 for the 10-city composite. But of greater concern is the rate at which prices are falling – 13.6% annually, which is the fastest decline since records began.
We also learned last week that home vacancies surged to 2.9% for the first quarter which was a full percentage point higher than average. It means that fewer homes on the market are being rented. A total of 2.2 million homes for sale during the first quarter sit vacant which is one million more than average. Meanwhile, a record 4.1 million vacant homes are for rent and the rental vacancy rate rose to 10.1% in Q1 according to the Wall Street Journal. The good news is that the burgeoning supply of rental accommodation available should keep rents in check and that will keep inflation down. Owner equivalent rents (OER), a convenient metric designed by the Fed to keep home prices from skewing the inflation data, is one of the largest components in the Fed’s inflation model. But the reason for growing vacancies could well be found in the foreclosure statistics. Foreclosure fiasco We also learned last week that U.S. foreclosure filings surged 112% in Q1-08 from the same quarter last year. This is on top of the 75% jump between 2006 and 2007 and according to the Mortgage Bankers Association foreclosures in 2007 were the highest ever. A total of 650,000 homes were in some stage of foreclosure during Q1 and according to RealtyTrac’s Rick Sharpa, foreclosures are up 23% from Q4-07. At last count, foreclosed properties represented one-in-nine homes on the market across the country. There were 1.5 million homes foreclosures in the U.S. last year and that number is growing rapidly. According to a recent report by Barclays Capital, roughly half of subprime and Alt-A mortgages made in 2006 and 2007 may be worth more than the home value by mid-year which would put approximately $800 billion in mortgage debt at greater risk of default according to Bloomberg news April 29. Report authors Ajay Rajadhyaksha and Derek Chen were quoted as saying, “mortgage loans are moving underwater at a very sharp pace, far more than suggested by aggregate home price data.” This can only mean one thing, foreclosures will continue to escalate. Barclays estimates that of $1.2 trillion in Alt-A loans outstanding, $770 billion were from 2006 and 2007 and about $850 billion of $1.45 trillion outstanding in subprime loans were from those years. To put these numbers in perspective, there was a total of approximately $11.5 trillion in mortgages outstanding in 2007. The default rate from all subprime loans underlying bonds jumped to a record 26.6% from 11.6% the year before according to FBR Investment Management. Soaring foreclosures means a growing pent up supply of homes that will one day in the not-too-distance future hit the market. Adjustable rate mortgage resets (see graph 1) won’t help.  Graph 1 – Chart showing schedule of adjustable rate mortgage (ARM) interest rate resets. So what does this mean for stocks going forward? Strangely, homebuilders may hold the answer. Building for yesterday’s tomorrow Based on the recent jumps in homebuilder stocks, investors have again become bullish on the sector. After hitting a low of 117.41 during the week of January 11, 2008 the Philadelphia Housing Index ($HGX) has been rallying. It ended the week of April 25 at 144.16 for an impressive 23% gain. This has had the very predictable consequence of prompting pundits to again call a bottom for builders and the housing market in general. Before deciding whether this conclusion is justified or just another example of brokers and money managers ‘talking their books,’ let’s take a quick look at the data. John Mauldin made an interesting point is a recent newsletter about the difference between new home sales and housing starts. Here are some charts to demonstrate the discrepancy.
Figure 2 shows year-over-year changes in new home sales that could be perceived as suggesting a bottom given that the declines have leveled off. As of March, new homes sales were selling at a rate of 526,000 per year and sales declined 37% in the last year. Figure 3 shows housing permits and housing starts. As of March, permits were being issued at an annual rate of 927,000 and starts at 947,000 per year. Even with the rapid declines in both housing permits and starts, builders still appear to be bullish on the future of their industry based on the number of new homes they are building. As we see from Figure 4, starts exceed new home sales by more than 400,000 units per year and while this excess has been declining, it has occurred more slowly than sales declines. At the present rate, it is only a matter of time before the excess in new homes being built every year equals total new home sales. In October 2006, the excess of supply being created was 518,000 units. It peaked in August 2007 at 646,000 then dropped to 390,000 in December before beginning to surge again hitting 500,000 in February. In March, the excess stood at 421,000. Between October 2006 and March 2008 (the period in Figure 4), the inventory of unsold new homes on the market grew from 249,000 (a 7.1 months supply) to 468,000 units (11 months) in March. It was the highest inventory of unsold new homes since September 1981. So in spite of the fact that 526,000 new homes are selling per year with an unsold inventory of 468,000 homes for sale, builders continue to add another 947,00 homes per year to that inventory! Adding excess inventory is not a bad idea in a growing market since it provides a buffer between growing supply and current demand. But continuing to provide overproduce is financial suicide in a falling market.
So is this latest homebuilder rally justified? This isn’t the first time investors have jumped the gun. Look at the last big rally in $HGX (Philadelphia Housing Index) when the index jumped from 187 in July 06 to 257 in February 2007 only to plummet to 117 by the following January. Given the fact that stock price leads fundamentals and that supply will continue to exceed demand for the foreseeable future, I expect this homebuilders rally to be short and have an unpleasant ending as these undeniable realities of the market continue to negatively impact builder’s profits. But what does this mean for the larger housing market and stocks going forward? Take a look at the VectorVest composite of 26 homebuilders trading on U.S. exchanges in Figure 5. It shows a sharp peak in July 2005 after which the index rapidly fell, breaking its four-year trend support line in May 2006. Tail wagging the dogWhy is the new housing market worth watching so closely? Although new homes are the tail representing just 15% of the overall housing market in the U.S. they have shown a tendency to lead the other 85% existing home market as we see from Figures 1 and 5. Homebuilder’s stocks peaked in July 2005, eleven months before existing home prices (Figure 1) and builders broke their uptrend support line to the downside a full eighteen months before home prices did the same. Although the period between builder action and housing market reaction has varied, the result is undeniable. Where the homebuilders go, the housing market has so far followed. There is also growing evidence in the subprime and credit problems that housing is exerting a larger than life influence on the stock market. Given the rate at which homebuilders continue to swell the supply of new homes for sale, we don’t expect builder’s stocks to experience any sort of sustained recovery until the situation changes. It may mean that a number of them go bankrupt in the process but eventually equilibrium will be restored. This does not bode well for the long-term outlook for the overall stock market – especially with the election drawing near. Why is the election important? We have written about the influence elections election exert on stocks and that 93% of Dow gains since 1902 have occurred in the two years (26 months actually) leading up to elections. In re-examining our election cycle research this week, we also learned that a strategy that bought the Dow 30 at the mid-term year low 25 months before each election and sold at the end of November in each election year would not have had one losing trade since 1942! That’s right. In a total of 17 trades between 1942 and 2006 (ignoring the cost of commissions), not one lost money. It is also important to point out that with the odd exception of 1987 there has not been one significant bear market or recession during the two years leading pre-election period since World War II. But all the inflationary handouts that governments employ to get elected must be paid for. As a result, the two years following each election are brutal and have accounted for every major bear market and recession since WW II. Given that the government giveaway machine will continue to pump the economy until election time, we may avoid a serious melt-down for the next few months in spite of the situation with homebuilders and the housing market. But it will only mean the piper’s bill has gotten bigger in the meantime and it is one that will ultimately have to be settled after the election hysteria has died down. Article Links: Lenders Swamped by Foreclosures Let Homeowners Stay More Subprime, Alt-A Mortgages May Head `Underwater' http://www.bloomberg.com/apps/news?pid=20601110&sid=a8lCfnqBcJU4 ---------------------------------------------------------------------------------------------------------------------- If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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| Last Updated ( Tuesday, 26 August 2008 ) |
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