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August 25, 2006

Housing Weighs on the Economy
by Chad Hudson

There was little surprise that the housing market remained weak in July. Existing homes sales fell 4% from June to an annual rate of 6.33 million in July. This was 12.5% lower than last year. This was the slowest rate of home sales since January 2004. The median price gained 0.9% from last year, the South was the only region to experience a year-over-year gain. The West had its second consecutive month of lower year-over-year prices. Sales in the West were 18% lower than last July. This was the seventh month of double-digit yearly decline for the West. Not only are fewer homes selling, but more are coming on the market. In July, the number of homes for sales jumped 118,000 to 3.856 million. Combined with slower sales, the number of months supply jumped to 7.3. This is two months longer than in January.

On Tuesday, Toll Brothers reported third quarter earnings of $1.07. This was slightly ahead of analysts estimates, but was 16% lower than a year ago. Similar to other homebuilders, Toll Brothers wrote off $23 million related to land. Excluding this charge earnings were down 9%. The homebuilder also revised its guidance for the full year to $4.41 to $4.63 from previous guidance of $4.69 to $5.16. Wall Street had already reduced its estimates to $4.40. The company didn't provide earnings guidance for 2007, but said that revenue would fall due to a 10-19% drop in deliveries and a 7% drop in the average selling price. Part of the drop in average selling price will be due to a shift to smaller homes. In response to a question whether or not the company felt the market was starting to bottom, it said, "but I don't see a turnaround in any of the markets specifically."

Last week, Home Depot reported that the slowing housing market has adversely affected its outlook. On Monday, Lowe's echoed similar comments. Lowe's reported an 11% gain in second quarter earnings, which was inline with analysts' estimates. Same stores sales increased 3.3%, driven by a 4% gain in the average ticket. It also mentioned that promotional activity increased during the quarter. It was interesting that Lowe's noted that even as it saw evidence that customers cutback discretionary spending, it still had strong sales of high end items in some product lines. Similar to Home Depot last week, the home improvement retailer lowered its guidance for the second half of the year. Same store sales are expected to be flat to up 2% during the third quarter as "near-term pressures on the U.S. consumer have led to a more cautious outlook for the balance of the year."

Also playing a role in the housing market is a shift in psychology Just a year ago the media was hyping the housing boom highlighting investors that had switched from investing in the stock market to investing in residential housing. Today, there are an abundance of stories highlighting the bursting bubble. This week, the Wall Street Journal ran two such stories. The first highlighted the problems of "stated income" loans. The article mentioned a study done for the Mortgage Bankers Association by the Mortgage Asset Research Institute found that 60% of a sampling of 100 loans from one lender had income overstated by more than 50%. On Wednesday, the Wall Street Journal highlighted one homeowner that placed her house on the market for its 2005 appraised values of $1.1 million. Long story short, she ended up selling it for $530,000. Over the weekend, Barron's noted that only 1% of WaMu's option ARMS were in negative amortization at the end of 2003. In 2004, it moved up to 21% and has jumped to 47% at the end of last year.

While housing has been decisively weak, the data has been mixed for the rest of the economy. The Philadelphia Fed index was much higher than expected for August. The index measuring business activity in the Philadelphian area rose 12.5 points to 18.5. This was the highest level since April 2005. Most of the strength came from higher orders (+5.6 to 15.7) along with higher shipments (+12.1 to 22.3). This was the first report that offered a look at how the economy is doing in August. The only component to fall was for the number of employees. However, while number of employees slipped the average work week jumped to the highest level since April 2005. The outlook for the next six months is not as rosy. The expectations index dropped 8 points to 7.4. The largest drop was in prices received. New orders and shipments actually rose, as did the number of employees.

While the Philadelphia survey rose this month, the Richmond Fed fell in August after rising last month. The one interesting part of the Richmond survey was the response to prices paid and prices received. Manufactures said that prices paid increased 1.88%, which was the smallest increase since August 2005. However, prices received jumped to 2.61%, which was the second highest increase since the survey started in late 1993. The largest increase was in November last year after commodity prices jumped following the hurricanes. This was similar to the recent PPI and CPI data that showed consumer prices increased more than producer prices in July.

The debate among investors is focused on if the Fed has just paused or is done rising rates. Most investors think that economic growth is slowing and lower aggregate demand will quell inflation pressure. In a speech yesterday, Michael Moskow, president of the Federal Reserve Bank of Chicago, noted: "The risk of inflation remaining too high is greater than the risk of growth being too low." He also said that "We need to balance the benefits of gaining new information against the costs of waiting too long. If inflation stays stubbornly high while we wait to see the effects of earlier policy actions, inflation expectations could increase - and that would be very costly." He also addressed the beleaguered housing market, "While we factor a housing slowdown into our outlook, there is some evidence - such as higher rates of cancellation in home-building contracts - that the slowdown could be more extensive."

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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