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Stephen Shefler

Stephen Shefler

Steve has been an astute observer of the big economic picture for many years now. He correctly foresaw that a housing/subprime crisis was coming as…

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The Housing Depression and Why It Suggests Improved Future Economic Growth

For the home construction industry, the recent recession has been a depression. The data tell a brutal tale. In 2005, construction started on 2,068,000 homes. In 2009, construction began on 544,000 homes - a drop of 73 percent. This drop was by far the steepest in new home construction since the Great Depression.

From the economist's perspective, the deviation from the norm was especially telling. The government began systematically collecting data on new home construction in 1959. In the following 46 years, to the peak of the recent housing bubble in 2005, annual new home starts never fell below 1,000,000 units and averaged 1,525,000 units. Starts ranged from 1,013,000 million in 1991 up to 2,068,000 million in 2005. In short, starts in 2009 were 64 percent below the long term average and 45 percent below the 1991 low point.

The prospects for improvement in 2010 are modest. While starts have averaged 629,000 (annualized) for the first six months of the year, they have declined sharply following the expiration of the home buyer's tax credit. The National Association of Home Builders (NAHB) and leading economists expect about 600,000 starts for the full year, only a 10 percent improvement over last year's dismal numbers.

The negative GDP numbers at the heart of the recent recession were in large part driven by falling home construction and its multiplier impact on satellite industries such as lumber mills and home appliance producers. The drop in housing construction has been a major contributor to falling GDP since construction peaked in 2006 following the peak in starts in 2005. For the next three years, it steadily contributed to dropping GDP by between 0.25 and 1.4 percent per quarter, according to Bureau of Economic Affairs (Department of Commerce). Losses directly attributable to construction accounted for fully 27 percent of employment drop during this period. Added to those direct losses is the multiplier effect on related areas of the economy. The NAHB claims that three jobs outside home construction are created for every job added by home construction. If this ratio is correct, home construction has an unusually high multiplier impact on economic growth or loss in national product output.

All this bad news is potentially good news for the economy as is so often the case. The economy moves in cycles and tends to revert to its mean over time, often overshooting either up or down. An increase from 600,000 starts in 2010 to 1,000,000 starts in 2011 or 2012 would be a substantial catalyst for economic growth, especially given the multiplier impact. A climb up to 1,000,000 starts would be a healthy 67 percent increase from a 600,000 level, but it would still be fewer starts than at any point in the 46 year period prior to 2005.

Given how far home starts have fallen below their historical norm and that they are now considerably below their prior nadir, the assumption is that their potential for further decline is both unlikely and limited. Even if home starts were unexpectedly to decline by 100,000 next year to a new all time low, that drop would pale in comparison to the drop of 1,524,000 starts between 2005 and 2009. Thus, there appears to be limited potential for a further decline in housing starts, and even if a decline took place, it would result in a far lesser loss to GDP.

Without a further significant and unlikely decline in new home construction, a renewed retreat into recession is also unlikely. While a severe drop in housing production was at the core of the recent recession, the low potential for further decline suggests that we are not positioned for a repeat performance any time soon. A sharp drop in some other component of GDP potentially could lead to a renewed recession but no other key component currently looks positioned for such a setback.

Another upside of the downside is how far the inventory of unsold newly built homes has fallen. New home inventory has now recorded 34 straight months of declines and has not recorded a monthly increase since May 2007. New home inventory on a seasonally-adjusted basis declined to 210,000 units in June, the lowest level since 1968. Inventories are at less than half their peak levels in 2005-06. Rising demand and low inventories create the basis for accelerated growth. The combination of these factors is the basis of many economists' optimistic scenarios for home construction to drive GDP higher.

The potential improvements in home construction and seemingly limited potential for further declines are in fact major components of predictions by some economists that the United States will experience healthy growth and avoid a retreat into another recession. In June, the Federal Reserve minutes contained the following prediction:

"Looking further ahead, the central tendencies of participants' projections for real GDP growth were 3.5 to 4.2 percent in 2011 and 3.5 to 4.5 percent in 2012. Participants generally expected a rebound in spending on housing, consumer durables, and business capital equipment."

For housing, the underlying assumptions are that starts will revert back toward their historic norms and home production will ramp up due to low inventories. If these projections play out as predicted, new home starts will increase by at least 15 percent annually during the next two years in order to achieve the projected gains in GDP.

If the Fed's predictions of a cyclical bounce back prove accurate, the economy will be climbing at a favorable rate and the stock market should respond favorably.

But beyond the major cyclical trends, a host of factors will ultimately determine the rate of new home construction: (1) the inventory levels for existing homes, which may increase with additional foreclosures; (2) the vacancy rate in existing homes; (3) the level of household formation; (4) the rate of increase in national employment; and (5) the level of interest rates for mortgages. All of these markers bear close scrutiny.

Will the cyclical assumptions of the Federal Reserve prove right? This is a matter of considerable debate and there are some very prominent detractors. For the investor, it is very important to understand and keep in mind these assumptions. The wise investor will watch to see whether there are improvements in home construction that match the expectations for healthy GDP growth going forward.


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