On Wednesday, I was listening to the radio when I heard an advertisement for a class on "home flipping," which gave me chills. After all, hadn't we learned any lessons from the housing bubble and ensuing financial crisis? Now, one anecdote does not a trend make, but it did get me wondering about whether or not the housing recovery was a little too good to be true. After doing research, I feel pretty confident that a rerun of the 2007-2009 price collapse and financial crisis is highly unlikely, but I do think there is a strong probability for a stall in the housing recovery that could have significant repercussions on your portfolio.
Let's begin very broadly and look at median home prices, which I think may surprise you. Obviously, prices crashed in 2007, and you're probably aware they've recovered a good bit. But did you know they're actually at a new high, surpassing their bubble peak?
With the benefit of hindsight, we know that our last peak was unsustainable, an almost artificial high, similar to the NASDAQ hitting 5000. It represents a level we should not reach for some time because it never made sense in the first place. Yet, here we are in the housing market. Now, I'm not prepared to call a crash based on just one indicator, especially in a market as complicated as housing, impacted by supply, household formation, inflation, wages and interest rates. We need to drill down further into these components of pricing.
Fortunately, there is an index that captures some of those components: the home affordability index, which measures monthly mortgage payments. A reading of 100 means a median household could afford the median home, while a reading of 120 would indicate they could afford a home 120% of the median. Thanks to lower rates, affordability soared the past few years but has noticeably dropped the past 5 months.
Compared to the housing peak, affordability is up 40% while prices are up less than 5%, so it's clear that lower interest rates have played a major role in the housing rally. From this angle, prices would seem far less lofty as monthly mortgage payments remain well below their 2007 peak, making a default wave less likely. However, it may be that housing is extraordinarily vulnerable to a gradual increase in interest rates as mortgages become as expensive as they were in 2007.
Lower interest rates also must spark another concern: the entrance of investors in the housing market looking to make a quick profit fueled by cheap money. For instance, Blackrock now has a $64 billion property fund (for details see here) while other investors like John Paulson have been buying tons of properties. This demand is unsustainable and provides merely a transitory boost to home prices. When they start selling, they could seriously weigh on prices. In a sense, they have stolen future demand to the detriment of future home prices.
That's why when examining the longer term value in homes, I prefer ignoring interest rates, which will gradually normalize and focus on the home price, income ratio as it should revert to the mean over time. Here is that chart:
If you ignore the years of the housing bubble, this ratio is at its longer term high. That would suggest, outside of a bubble, home prices are unsustainable at six times the median income. This reality does not mean that home prices have to fall, rather they just cannot keep growing faster than income. However with wages pretty much stagnant, this indicator suggests that home prices should stagnate a bit from here.
And we are starting to see some signs of a breather in the housing market. New single-family construction permits, for instance, fell last month. New home sales have wobbled a bit, and mortgage applications have collapsed under the weight of higher rates with Wells Fargo (WFC) recently announcing a job cut of 2,300 in its mortgage unit due to weak originations.
Longer term, young Americans seem more comfortable renting versus owning, which leaves a structurally weaker housing market. First-time home purchases are also highly correlated to being married, and with many getting married later, that first home purchase comes later in life. Lastly, the American population is aging with baby boomers entering retirement. Obviously, those entering retirement are more likely to downsize than upsize or just keep their home. In the US, there are secular trends that point to a less robust housing market.
So in summation, whether looking at home prices (at all-time highs), affordability (declining), or the income ratio (over-extended), we have a housing market that looks a little ahead of itself but certainly not in crash territory. Again to be absolutely clear, I am not calling for a crash, more of a stagnation to mild downtrend with major long-term cyclical issues. We also must be wary about the high level of investor ownership in housing which could distort the market by running for the exits at the same time.
The stock market is beginning to sense some issues in the housing market based upon the action in the homebuilders over the past three month: Lennar (LEN) is down 21%, Pulte (PHM) 27%, and D.R. Horton (DHI) 26%. Homebuilders are leveraged bets on home prices and volumes. In a price stagnant world, they will suffer disproportionately hard. DHI mostly serves first-time homebuyers who are delaying purchases and have the tightest access to credit, so they would appear to be the most vulnerable of the major builders. Frankly though, I don't see a buy in the group.
Interestingly, the home improvement stocks have still been reporting decent numbers, in particular Home Depot (HD) and Lowe's (LOW) with Lowe's actually rallying the past 3 months. Similarly, some companies whose products are used in renovations have seen inflows, i.e. Whirlpool (WHR) up 6%. Conversely, others like Masco (MAS) have fallen hard, down 11%. On the whole, people put off renovations when they see home prices falling because there is little perceived value in a renovation. Some of these firms are also still benefiting from the rebuilding around Super Storm Sandy, though the effects should dissipate in coming quarters. However if my thesis about a stalling housing recovery is accurate, these stocks will underperform the market and should be avoided.
It appears to me that the housing market is ahead of itself, reaching bubble peaks in an environment filled with fast money which is pulling demand forward. Further, affordability measures suggest the move is long in the tooth while the secular trends point to less housing demand in the long run. Home prices seem pretty much maxed out, though a bubble-like collapse seems very unlikely. To me, there is little compelling value in the housing sector, especially when other industries are performing so well, like domestic energy and autos. The homebuilders provide the most leverage on the housing market and are breaking down first, which makes me concerned that improvement stocks like WHR and HD could follow. As the market realizes that home prices are not going to increase forever, I expect even more profit taking. While the improvement stocks are "less bad" than the builders, I see little value in any stocks dependent on a strong housing market.