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Today's Market WrapUp  02.07.2007  Mon  Tue  Wed  Thu  Fri  Puplava Archive

Housing Update
BY CHRIS PUPLAVA

Housing was the major component that helped fuel the economic expansion after the last recession. As such periodic analysis of housing’s decline will shed light into whether a hard or soft landing is in store along with a look at consumer expenditures. This week I will be looking at housing with a look at the consumer next week.

Housing’s importance towards consumer expenditures

To illustrate housing’s contribution towards consumer expenditures, take a look at cash out refinancing and its correlation with housing appreciation below. Leading into the last two recessions cash out refinancing plummeted as consumers cut back as housing prices cooled. Notice that both have recently peaked and have turned down, a potential warning sign.

Figure 1

Source: Moody’s Economy.com/Freddie Mac

To determine where cash out refinancing may be headed, a look at home appreciation sheds some light. There is a typical lag of one year between home price appreciation peaks and cash out refinancing level peaks as illustrated in the chart below where home appreciation has been advanced one year. The year-over-year (YOY) rate of change for homes has turned negative and is below the level of the last housing recession in the early 1990s. The magnitude of decline in housing appreciation does not bode well for cash out refinancing as it indicates a sharp contraction in cash out refinancing which would reduce consumer expenditures and slow GDP even further.

Figure 2

Source: Moody’s Economy.com/Freddie Mac, National Association of Realtors (NAR)

Another chart to illustrate the relationship between housing and consumer spending is shown below with the National Association of Home Builders (NAHB) Housing Market Index (HMI) and personal consumption expenditures (PCE). Currently there is a major gap between the HMI and PCE levels and either one or the other is off. Either consumer spending will contract further as it did in the 1990 recession, or housing has put in a bottom and is set to rebound sharply as it did in 1994 to close the gap between the two measures. The cash out refinancing data above indicates the former is set to contract and the data below supports this conclusion as a bottom in housing does not appear within sight.

Figure 3

Source: Moody’s Economy.com/NAHB, BEA

Housing Demand

To ascertain a bottom in housing, both demand and supply fundamentals need to be analyzed. Below is the YOY percent change in existing and new homes, a measure of demand. The contraction in demand began in 2005 and fell sharply for both existing and new homes during the initial pullback in housing demand.

Figure 4

Source: Moody’s Economy.com/ Bureau of Census, NAR

What the above figure shows is that both existing and new home sales have turned up recently though they are still at a negative rate of change. Additionally, in previous housing downturns demand does not fall off in a straight line as there are multiple bottoms before the final bottom occurs as housing contractions take place over years, not months. This can be seen in the two cycles during the 70s as two bottoms were witnessed in the early 1970s contraction and three in the middle to late 1970s contraction. The long contracting cycle that played out during the 1980s had multiple bottoms before the ultimate bottom occurred in 1990. The point being is that the recent upturn in housing sales should be taken as suspect for a final bottom when looking at historical patterns.

Additionally, housing demand is not likely to pick up against the backdrop of rising delinquency and foreclosure rates, hinting that the recent uptick in housing demand is temporary. Subprime delinquency rates have risen sharply since the start of 2005 as more and more adjustable rate mortgages (ARMs) reset at higher interest rates. Notice the dichotomy of delinquency rates between ARMs and fixed rate mortgages (FRMs) for subprime loans. Clearly ARM holders are feeling the pinch from higher rate resets while FRM holders are unaffected.

Figure 5

Source: Moody’s Economy.com/ Mortgage Bankers Association (MBA)

The same trend is seen in subprime foreclosure rates where subprime ARM loan holder’s foreclosure rates have risen 48% from 3.16% in 2005Q2 to 4.68% as of 2006Q3; at the same time FRM loan holders have continued to decline.

Figure 6

Source: Moody’s Economy.com/ MBA

Figure 7

Source: Moody’s Economy.com/ MBA

What makes the foreclosure and delinquency rates as well as higher ARM 1-Yr rates even more worrisome is the popularity of ARMs over FRMs during the recent housing boom. The figure below shows the surge in ARM loans in 2004 over FRM loans due to the spread between fixed rate and adjustable rates which reached its peak in late 2003 into early 2004, with the spread between the two rates reaching nearly 3%.

Figure 8

Figure 9

Source: Moody’s Economy.com/ MBA

The surge in ARM popularity as well as the increasing number of delinquency and foreclosure rates has banks taking notice as they have tightened their lending standards to reduce losses on delinquent loans.

Figure 10

Source: Moody’s Economy.com/ MBA, Federal Reserve Board

In light of the above figures, the recent uptick in housing sales is likely only a short-term bottom as credit quality continues to worsen and bank lending standards continue to tighten. With continued weakness in demand, the supply of homes is likely to remain high.

Housing Supply

Looking at the months' supply of new and existing homes shows a greater turnaround than does home sales (Figure 4). This indicates that the recent pick up in demand is not the greatest factor in the decline in the months supply of homes, but actually a greater decrease in new and existing homes for sale. As was stated in regard to housing demand in Figure 4, housing cycles typically have multiple tops and bottoms. In terms of months of supply for new and existing homes, there are typically several tops in months of supply instead of a single top. This also makes the recent plunge in months of supply suspect and should not be taken as a definitive signal that housing has bottomed.

Figure 11

Source: Moody’s Economy.com/ Bureau of Census, NAR

A reliable indicator for housing bottoms has been the ratio of completed homes for sale relative to total homes for sale. Builders typically rush to clear their inventory of homes already in construction to reduce stranded capital during housing downturns while at the same time holding off construction on units already approved but not yet started. This typically leads to a surge in inventory while completed homes come on the market at increasing rates before buying interest is able to soak up this increase in inventory. Once that occurs, the months of supply contracts and builders slowly begin construction on approved units not yet started while demand continues to firm.

Looking at Figure 12 below indeed shows the ratio of completed homes relative to total homes as a reliable indicator at determining housing bottoms as measured by bottoms in housing starts. The ratio of completed to total homes for sale is inverted to show the inverse correlation with housing starts. Below the ratio has peaked (“bottomed” in figure) with great accuracy at coinciding points with a bottom in housing starts. As the ratio has yet to turnaround the decline in months of supply of homes is likely only temporary as the housing downturn plays out.

Figure 12

Source: Moody’s Economy.com/ Bureau of Census

There is a strong correlation between housing supply and interest rates, as higher interest rates makes housing less affordable. Past peaks in supply typically were identified by a sharp decrease in interest rates with the 1990 mid-cycle slow down as the only exception. The likelihood of the recent peak in months supply of homes is doubtful unless the Fed cuts interest rates sharply as it has in reacting to past housing downturns to make homes more affordable. The affect of declining rates would likely have an even greater cushioning affect on the current housing recession due to the higher popularity of ARMs in this cycle compared to previous cycles, allowing ARM holders to refinance at lower rates and reduce the delinquency and foreclosure rates.

Figure 13

Source: Moody’s Economy.com/ Bureau of Census, Federal Reserve Board

Previous Cycle Experience: The Big Picture

Another indicator to measure previous housing cycles is the level of residential fixed investment as well as its relationship to GDP. Whenever residential fixed investment falls to or below a -10% YOY rate of change we have seen a recession since 1948 with two exceptions: 1951 and 1967. Residential fixed investment is currently at a negative 12.64% YOY rate, marking the eleventh time this has happened in more than five decades with a resulting recession uncertain at this point.

Figure 14

Source: Moody’s Economy.com/ BEA

However, the percentage component of residential fixed investment to GDP as well as the demand and supply analysis above point to continued weakness in housing and the hopes of a bottom far removed. Residential fixed investment has averaged 4.8% of GDP since 1950, with the recent peak coming in at 6.3% in 2005Q4, two standard deviations above the average. Previous bottoms in housing are marked by declines in the percentage of residential fixed investment to two standard deviations below the mean at 3.3%.

Figure 15

Source: Moody’s Economy.com/ BEA

Quick question -- does the current decline in Figure 15 look like it's bottoming? At the current rate of 5.3%, the decline has only gone through a one third retracement (1% decline of a 3% peak to trough spread) after one year, pointing to continued weakness in housing for many months and possibly years to come unless the Fed starts cutting interest rates in a hurry. In summary, don’t be fooled by market pundits calling for a bottom in housing as the data is far from conclusive to warrant calling for a bottom.

TODAY'S MARKET - Economic Reports

Productivity and Costs – 2006Q4

Productivity surprised on the upside as nonfarm business productivity rose 3% (SAAR), above the consensus expectations and higher than the -0.1% decline seen in the third quarter. Also encouraging in the report was a 1.7% annualized growth in nonfarm unit labor costs, down from the third quarter rate of 3.2% and below the consensus estimate of 2.1%.

Source: Moody’s Dismal Scientist
Data: Bureau of Labor Statistics

MBA Mortgage Applications Survey

Mortgage fell 0.2% last week, mainly the result of a 0.8% decline in purchase applications while refinance applications rose 0.2%. The contract rate on the 30-yr FRM decreased 6 basis points to 6.23% with the 1-yr ARM falling 2 basis points to 5.84%.

Source: Moody’s Dismal Scientist
Data: Mortgage Bankers Association of America

Oil & Gas Inventories

Crude oil inventories fell 0.4 million barrels last week, in stark contrast to an expected build of 1.4 million barrels. Part of the decline in crude oil inventories was from a decline in imports of 400,000 barrels per day from the previous week’s average of 10 million barrels per day, indicating OPEC is making good on its promise to cut production. Distillate inventories fell 3.7 million barrels, greater than the 3.2 million barrel drawdown expected. Gasoline inventories rose 2.6 million barrels, greater than expectations for a 1.8 million barrel increase.

Source: Energy Information Agency (EIA)

The Markets

The markets traded initially up on the positive inflation news in the productivity report with the NASDAQ showing the greatest gains on news of CSCP beating Wall Street expectations for its second quarter, as well as raising its Q3 and Q4 guidance upwards. The Dow was essentially flat, posting a gain of 0.56 points to close at 12666.87. The S&P 500 was up 2.02 points to close at 1450.02, and the NASDAQ put in the largest gain, rising 19.01 points to close at 2490.50. Investors purchased Treasuries today with the 10-year note yield falling to 4.745, declining 2.0 basis points. The dollar index was also down on the day, falling 0.06 points to close at 84.72. Advancing issues represented 55% and 59% for the NYSE and NASDAQ respectively, with up volume representing 50% and 73% of total volume on the NYSE and NASDAQ.

Energy commodities were down after the release of the inventory data after starting the day in positive territory, falling more than a $1/barrel. Precious metals were mixed with gold falling $1.75/oz to $651.55/oz and silver falling $0.0063/oz to close at $13.615/oz. Base metals were mostly down on the day despite falling LME inventories, with nickel leading the pack up, down 2.32% even though LME inventories fell 7.45% and are down 55% year-to-date..

Overseas markets were mixed with the European markets putting in the best performances with Germany’s DAX and France’s CAC-40 indices up 0.58% and 0.46% respectively. The weakest markets were Brazil’s Bovespa and Japan’s Nikkei 225 indices, down 1.68% and 0.66%.

The advancement in the markets today was mixed as only half of the ten S&P sectors were up. The technology sector put in the greatest performances today with help from a 6.44% advance by PMC-Sierra (PMCS) and a 4.72% gain in Broadcom (BRCM). The weakest sector of the day was energy, down 0.75%.

Chris Puplava

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