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Has Housing Topped?

Retail sales continue to be the focus point for investors. As expected, retail sales rebounded last week after being depressed the prior week due to winter storms. The Bank of Tokyo-Mitsubishi reported that chain store same store sales rose 2.1% last week. The gain also pushed the year-over-year gain to 5.1%. This was the first increase in the year-over-year sales since November 15. Despite this good news, Wal-Mart said its sales were trending toward the low end of its plan of 3% to 5% same store sales growth. Likewise, Target said its sales were below plan. On Wednesday, Best Buy said that sales were "modestly below expectations so far in December because of inclement weather right here in the Northeast." Because weather has been the main reason for lackluster sales, the International Council of Shopping Centers left their forecast of 3.5% to 4.5% growth in holiday spending based on shoppers having enough time until Christmas to finish any shopping the storms might have deferred. The weak sales have rattled investors. Going into the holiday shopping season investors pushed the S&P 500 Retailing Index to within 2% of its all-time high. The disappointing sales have resulted in a drop of 5% this month as measured by the S&P 500 retailing index.

This week, the Department of Commerce released November housing starts and building permits. The number of housing starts increased by 110,000 to 2 million. This was the highest level since February 1984. Conversely, the number of permits issued dropped by about 70.000. Housing permits are commonly used as a leading indicator for the housing industry. While the two do not move in tandem all the time there is good correlation. In November, not only did housing permits decline by about 70,000, but the number of permits issued was 196,000 less than the number out houses started. This was the largest difference since March 1994. Interestingly, in March 1994 this marked the beginning of a steep 35% sell-off over the next eight months in the S&P Homebuilder Index. This was preceded by an almost 300% gain that started in late 1990. Incidentally, the Fed also increased interest rates during this time by 300 basis points to 6.0%. Today, homebuilders state that an increase in interest rates will not hurt business. They say that the rebounding economy will add as many buyers as the higher interest rates take away. While it might not hurt business, recent history reveals that rising interest rates have a dramatic effect on the stocks of homebuilders. The other time the Fed tightened monetary policy was from June 1999 to May 2000, during which the homebuilding stocks dropped by one-third.

The current rally in housing stocks started in March 2000. Since then, the S&P 500 Homebuilder index had leapt almost 450% at the peak last month. While the homebuilders have continued to report stellar results, there are some chinks that are starting to appear. Last week, Hovnanian Enterprises issued earnings guidance that was lower then analysts' had already forecast. This was interpreted as downward revision. Additionally, Lennar reported earnings that were 10% better than analysts' estimates, but that was all based on larger than expected land sales that analysts' were not including in earnings estimates. Excluding the larger than expected land sales, Lennar only beat estimate by about one penny, the smallest margin in at least five quarters. Results are still strong, but have moderated slightly from beating analysts' estimates by double-digit percent.

The strong housing market has also distorted the Consumer Price Index. Instead of using what homeowners actually pay for housing the Bureau of Labor uses a calculation called the "owners' equivalent rent." According to the website devoted to this component of CPI, owners' equivalent rent is calculated based on asking a sample, "If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?" In November, this question yielded an year-over-year increase of 2.1%. Instead of asking homeowners to pretend to by landlords, actual home prices could be used, but that would translate into way too much inflation for the Federal Reserve to be comfortable with. Another alternative would be to use what homeowners actually pay each month. One big caveat with this would be interest rates would have a sizeable effect at times. But for grins, using the increase in mortgage payments for the median prices house would cause the CPI to jump from a 2.1% year-over-year increase to a 2.9% year-over-year increase.

Using the median price of existing homes sales from the National Association of Realtors, October median prices increased 8.2% from last October. Last November, 30-year mortgages averaged about 6.1% compared to 5.9% this year. Assuming a down payment of 10%, which might even be considered high now, the mortgage payment for the median homebuyer this November was $920.31. Last year, it was $868.84, or an increase of 5.9%. The fall in mortgage rates has helped reduce the monthly payment amount. If interest rates would have stayed the same, obviously the mortgage payment increase would match in increase in home prices. Since this is 22% of the CPI, by replacing 2.1% with 5.9%, the year-over-year increase in the CPI would be 2.9%.

I have argued that the consumer is motivated by monthly payments rather than the actual purchase price of goods. If this is accurate for homeowners, the following table shows the mortgage amount a homebuyer could borrow while maintaining the same monthly payment ($920.31) at different interest rates.

Interest Rate Mortgage Amount
6.1%: $151,867
6.5%: $145,603
7.0%: $138,330
7.5%: $131,620

It is easy to see how an increase in interest rates will have a detrimental effect on housing. If mortgage rates increased just 90 basis points from current levels to 7%, the amount that a homebuyer can afford drops by 9%. With the growing number of lenders requiring low down payments, a 9% decline in prices could cause a lot of heartache.

Due to the holiday next week, I will not be publishing a commentary. I wish everyone a safe and enjoyable holiday.

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