Orlando's Outlook: Housing has finally found its bottom
Bottom Line: It’s been apparent to us over the past two decades or so that investing in the housing market must be akin to studying the Bible, with the seven fat years followed by seven lean years. But after dealing with the plague and locust that housing investors experienced in the form of a near-90% collapse in stock prices from July 2005 to October 2011, we believe that the housing market has finally hit bottom. Look no further than the stock market itself, which has been a reliable forward-looking discounting mechanism for this very long-cycle industry. From its trough last October 4 to today, the S&P 500 has rallied by a healthy 27%. But the S&P’s homebuilders’ index—comprised of industry bellwethers Pulte, Lennar, and D.R. Horton—has soared by 164% over the same period of time. To be sure, housing fundamentals aren’t that strong just yet. But investors in housing stocks regularly look a year or two into the future, and attempt to discount into current prices their outlook for macroeconomic trends and developments. On that basis, we concur with the equity market’s powerful rally to date, and believe that housing fundamentals will continue to improve over the next several years.
Contribution to GDP accelerating Before the financial crisis hit, housing consistently accounted for 5% of annual Gross Domestic Product (GDP). But after the Great Recession, that contribution shrunk to zero. Over the past three quarters, however, housing has begun to rise much like a phoenix from the ashes, as residential investment inched up by 1.3% in the third quarter of 2011, leapt by 11.6% in the fourth quarter and surged by a powerful 20.0% in the first quarter of 2012. So of the first quarter’s overall 1.9% GDP growth, housing contributed 0.4 percentage points. Our outlook remains similarly bullish for housing’s expected contribution to consolidated GDP when the second quarter is flashed on Friday, July 27.
Home builders are confident The National Association of Home Builders’ (NAHB) Housing Market Index (HMI) recently spiked to a five-year high of 35 in July from 29 in June, which represents the strongest sequential improvement in this metric since September 2002. To put this data series into some historical perspective, the HMI peaked at 70 in July 2005, plunged to a record low of 8 in January 2009, and gradually improved to 14 in September 2011. Over the past 10 months, however, the HMI has suddenly gone vertical, surging from 14 to 35, which clearly indicates the increasingly confident nature of both home builders and home buyers.
So why is everyone now so confident about the housing industry?
- Housing affordability is at a record high Over the past seven years, housing prices have plummeted from egregiously overpriced to very cheap, while incomes have begun to recover, as the U.S. economy emerged from the Great Recession. As a result, the ratio of average existing single-family home prices to per capita income is just off of a record high.
- Record low mortgage rates Thirty-year fixed-rate mortgages are now at 3.82%, 15-year fixed-rates are at 3.14%, jumbos are at 4.32%, and five-year adjustable mortgages are at 2.95%. There’s also been a surge in refinancing applications that banks are trying to process (which suggests that they need to hire more people). While banks have picked up the pace of lending, we need to see stronger trends, along with more reasonable appraisals.
- Household formations are rising During the depth of the Great Recession, we noted the “Walton Family Syndrome,” in which grandparents moved in with their kids, and unemployed recent college grads moved back in with mom and dad, placing three generations under one roof and cratering the pace of household formations to near zero in 2009. But household formations have since recovered to about one million a year, which is still below the historical average of about 1.25 million, and well below the peak levels of about 2.0 million per year. Importantly, the Pew Research Center reports that one in five college graduates aged 25 to 34 is still living at home because of the economy, so there’s a lot of catch-up that can be generated as employment trends improve.
- Mortgage delinquencies have peaked Mortgage delinquencies peaked at 10.06% in the first quarter of 2010, and they have fallen steadily to 7.40% in the first quarter of 2012, a positive trend we expect to continue. They had been at 4.84% in the first quarter of 2007.
- Starts and permits are rising Housing starts in June rose to 760,000 units, its highest level in four years, and nearly 70% higher than the cycle trough at less than 500,000 units in February 2009. Building permits are now sitting at 755,000 units, a 58% increase from the cycle trough three years ago.
- Home prices starting to rise The Case-Shiller home price index is a rolling three-month average that peaked in May 2010 and has been in negative territory on a year-over-year basis for the past two years. While the pace of decline has slowed thus far this year, prices have actually risen on a month-over-month basis for each of the last three months.
- New-home inventories at a record low While sales are at a two-year high at 369,000 units, developers simply stopped building when demand disappeared, leaving a record low of 144,000 units on the market. Contrast that to the record high of 572,000 units on the market in July 2006.
But there are still several flies in the ointment:
- Jobs hit a soft patch We’ve added an average of 75,000 nonfarm jobs over the past three months, compared with an average of 252,000 during the December-through-February period. Moreover, the rate of unemployment has now been over 8.0% for 41 consecutive months, the longest such run of labor-market ineptitude since the government started collecting data in 1948. We need stronger and sustained job creation to kick the housing market into its next gear.
- Consumer confidence rolled over the past several months The Conference Board’s index peaked in February and the University of Michigan sentiment index rolled over in May, likely in response to the weaker labor market.
- Shadow inventory, underwater mortgages and foreclosures The existing-home market accounts for 95% of total homes, and no one has any reasonable idea of how much existing inventory may come to market over time, and whether banks will eventually decide to force the issue by foreclosing on underwater mortgages.
- Capital gains rate hikes? Existing homeowners who are looking ahead to the presidential election in November are concerned that President Obama may win re-election, and successfully implement his proposal to increase capital gains tax rates. As a result, some high-end homeowners are dumping their homes onto the market now ahead of the election, in the hopes of selling before the tax rates go higher.