The Importance of Housing Comstock Partners, Inc. Thursday, March 9, 2006
In our view the housing sector has been the main driver of economic growth. Therefore the weakening of this sector has ominous implications for continuing expansion in the period ahead. Throughout the expansionary cycle consumer spending has held up quite well despite the fact that the growth of employment, wages and salaries has been far weaker than in any other post-war cycle. In order to maintain their standard of living, consumers have been spending in excess of their income by converting rising home prices into cash by means of outright home sales, home equity loans and cash-out refinancing. This practice has come to be known by the overall term, mortgage equity withdrawals (MEW).
According to the Federal Reserve Board, MEW has soared from $93 billion in 1993 to $229 billion in 2000 and $640 billion in 2004. Indications are that the pace did not let up in 2005. It is therefore no surprise that consumer savings rates have declined as MEW has risen. From 1959 through 1992 the savings rate varied between 6 and 12% of disposable income. Since that time, however, the rate has steadily declined, reaching minus 0.7% in January. A recent Fed study, co-authored by none other than Greenspan, estimated that MEW accounts for four-fifths of the rise in home equity mortgage debt, and that about one-quarter to one-third of MEW directly financed consumer expenditures. Other estimates run as high as 50 or 60%.
The Greenspan study went on to say that as mortgage rates rise and loan affordability drops further, MEW would decline and the subsequent fall in consumer spending would lead to a drop in consumer goods imports as well as the intermediate goods associated with them. In addition, without the funds raised from MEW, consumers would also have to increase their savings rate, thereby reducing spending even further. This does not take into account the fact that a large portion of even the sub-par rise in employment over the last few years was a result of the boom in housing. According to Northern Trust an estimated 40% of the employment growth in the entire economic expansion was a result of soaring home sales and prices. This includes employment in home building directly as well as in ancillary factors such as supplies, real estate agents, appraisers, title searches and mortgage servicing.
It is clear that the housing market is already showing definite signs of softening. Purchase applications are down sharply as are pending home sales. The California Association of Realtors recently reported that January home sales were down 24% from a year earlier. While they also noted that prices were up 14%, falling sales are a leading indicator for prices. Massachusetts home sales were down 14%, from a year ago, and prices were flat. The University of Michigan survey indicated the percentage of respondents saying it was now a good time to buy a home dropped from the mid-80s to below 60. This indicator has generally led consumer spending by three quarters. The National Association of Home Builders (NAHB) housing market index is off significantly. This index is a combination of customer traffic at new home sites, current single family home sales, and expectations of single family home sales over the next six months. Anecdotally, a number of the leading home building companies have reported a softening in business. Housing starts are sure to follow on the downside, and any lingering strength will only add to an inventory situation that is getting worse every month.
The negative housing situation is being exacerbated by high energy prices, continued Fed tightening, an inverted yield curve, rising long rates, and declining real weekly earnings. Moreover, for the first time since 1980 the U.S., the EU and Japan will all be tightening at the same time. In our view this combination is likely to result in a weakening economy and disappointing earnings at a time when the market doesn’t expect it. While GDP is likely to grow at a 5% rate in the first quarter, this is already discounted by the market, while the indicators that tend to lead are pointing in a downward direction. The market is a discounting mechanism and usually peaks well before economic weakness becomes obvious. The S&P 500 is now selling at 18 times earnings against a past average of about 15. However, when earnings are at a record high as they are now, the market has generally sold at about 12 times. While anything can happen, the probabilities suggest limited upside potential and a major risk of significant decline.
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