Although both the new and existing homes sales reports are still showing year over year and month over month gains, if you dissect and examine the data beneath the "seasonally adjusted annualized" numbers that hit the headlines, it is apparent that the housing market has topped out and is getting ready to resume its bear market decline. Let's take a look at what's going on.
New homes sales for June reported Wednesday (July 24) by the Census Bureau (pdf) showed 497,000 on a "seasonally-adjusted, annualized" basis vs. 484k expected. However, the original 476k reported for May was revised lower to 459k. Although the median price was up 7.6% from June 2012 to June 2013, prices from April to June are down 11.5% at the median and 12.4% on average.
But there's a story not captured by looking just at the seasonally adjusted annualized rate, and bear in mind that we have no idea exactly how the Government statisticians calculate the "seasonal adjustment." However, the Census Bureau also reports the "unadjusted" data at the bottom of its report (the last page of the above-linked pdf).
If you look at that table, you'll see that on a "preliminary" basis, there were 48,000 new homes sold in June. Of that 48,000, 18k were not yet started, 16k were under construction and only 13k were actually completed. Now, bear in mind that the Census Bureau defines a "sale" as a deposit taken or a sales agreement signed. The reason this is important is because, over time, the cancellation rate reported by homebuilders has ranged anywhere from the high single-digits -- Toll Brothers (NYSE:TOL) has been high single-digits during this housing market bounce, for instance -- to over 40%, which was reported by a couple of the lower-end homebuilders right before the housing bubble popped. Furthermore, a completed home has a higher probability of actually closing than does one under construction or not yet started. As mortgage rates increase, the risk of cancellation of homes not completed therefore increases.
Let's say that, on average right now, and this is based on my scanning nearly all of the homebuilder 10-Qs in Q1 and what's been released so far for Q2, the cancellation rate is around 22% (KB Home (NYSE:KBH) reported 27%, D.R. Horton (NYSE:DHI) reported 24% and PulteGroup (NYSE:PHM) reported 14% for Q2, Beazer Homes (NYSE:BZH) was running in the low 30s). That means that of the 48k reported new home sales, only 38k will actually close. If I take that number and add up the home sales reported for the first six months of 2013, apply a 22% cancellation and then simply double it (which is generous given that the first half of the year is always better than the second half), I get an estimated 382,000 actual contract closings -- or real sales. That's quite a bit lower than the 497,000 seasonally adjusted annualized number just reported based on June's "deposits taken or sales agreements" signed.
It is my view that the spike in mortgage rates from mid-May to present has not only cut heavily into potential homebuyers' plans, it is going to result in a big spike in contract cancellations as these contracts always have contingencies, with financing being the easiest "out." In other words, the actual homes that get paid for and delivered is likely to be quite a bit lower than the number reported and acted upon by the stock market.
Even more telling is the action in the homebuilder stocks after the new home sales report and after D.R. Horton and PulteGroup reported their 2nd quarter yesterday. On Wednesday after new homes sales, the Dow Jones Home Construction Index (DJUSHB) plummeted 4.1%, after what should have been received as a very positive report. And yesterday, the DJUSHB plunged another 4.7% after seemingly good earnings reported by DHI and PHM.
What happened? As I outlined above, the numbers beneath the headline report for new home sales, specifically the May downward revision and the implication for an even bigger revision for June based on much higher mortgage rates, reflect the deteriorating demand-side of the housing market equation, especially since the 100 basis point move in mortgage rates has effectively eliminated a meaningful percentage of potential buyers. In my view, the reaction Wednesday in the housing stocks reflected the market pricing in the probability that homebuilders will be reporting a much lower level of new orders and a much higher cancellation rate.
In fact, the CEO of D.R. Horton commented in his earnings conference call that "homebuyers [are] shocked and disturbed by the rate jump," that he's "disappointed that rates rose so violently," and "traffic count has slowed since the rate rise." DHI close down 8.5% yesterday (Thursday, July 25) after being down as much as 10% after it released its earnings. In looking at its 10-Q, I noticed that DHI had burned through a significant amount of the cash it had raised through previous debt issuance, as it spent close $600 million during Q2 on building up its inventory. If I'm right about the housing market, DHI is going to end up choking on this new inventory. And keep in mind that DHI's Q2 numbers don't fully reflect the effect that higher mortgage rates will have on cancellations.
PulteGroup (10Q linked) was even more extreme than DHI. It closed down yesterday 10.3% from Wednesday's close after being down close to 12% earlier in the day. It's down 14.4% over the two-day period from Wednesday's open to Thursday's close. PHM not only missed its earnings expectation, but it also reported that new orders plunged 12% from Q2 2012 to Q2 2013. The fact that PHM reported a drop in orders was surprising, but the magnitude of the drop is what stunned stock investors.
I'm looking forward to more earnings reports from the homebuilders, although the Q3 reports will be the most interesting, as the numbers during Q3 will reveal just how high cancellation rates spiked up from the jump in mortgage rates and the effect of this spike on new orders. Despite the recent drop in the DJUSHB, Wall Street analysts continue to promote a highly bullish view of the housing sector and investors remain bullish on the stocks, as the DJUSHB is still 246% above its October 3, 2011 low of 171.
Base on my analysis and outlook for the sector, I think the homebuilders continue to be one of the better short-sale opportunities in the stock market. Because of their operating leverage, heavy debt use and profit-margin potential, typically in hot markets the homebuilders are literal money trees and the DJUSHB multiplied over 1100% during the great housing bubble. But when the market turns down, the operating and financial leverage turns against them quickly.
Because I think the sector has topped and turned down, and because I believe this fact isn't remotely close to being reflected in the stock prices of the individual builders, I think there's a high probability these stocks will re-visit their lows from 2011 and likely go even lower. I continue to like outright short positions in iShares U.S. Home Construction ETF (NYSEARCA:ITB) and SPDR Homebuilders ETF (NYSEARCA:XHB). I am currently short DHI, as discussed in previous articles, and I think short positions in any of the homebuilders trading in double-digits will make money. I specifically like Ryland Group (NYSE:RYL), Meritage Homes (NYSE:MTH), TOL and Lennar Corp. (NYSE:LEN) as shorts.