The Plunge In The Pending Home Sales Index Confirms My Housing Market Thesis

Includes: DHI, ITB, XHB
by: Dave Kranzler

The National Association of Realtors (NAR) released its Pending Home Sales Index Monday, which showed a 5.6% decline from August to September. No change in the index was the consensus Wall Street expectation. August's number was revised slightly lower as well. According to Zerohedge, this is the fastest rate that this particular metric has fallen in 40 months and the biggest miss of market expectations in 40 months.

According to the NAR Chief Economist, Lawrence Yun, this is the first time in 29 months that the index is not above year-ago levels. The index is at its lowest level since December 2012. While higher interest rates have played some role in declining home sales, today's data further confirms for me that the bounce in the housing market over the past 18-24 months has run its course and the market fundamentals are headed back into the bear market trend that started prior to the 2008 credit market crisis. On this basis, the homebuilder stocks have unrealistically optimistic expectations built into their market caps, which means they are currently overvalued and should be sold.

The media spin being placed on this data by the NAR is that "affordability" and the Government shutdown were the culprits in driving the index lower. However, the index is based on contract signings, which can occur typically anywhere from 30-90 days before a contract closes, meaning that the data for September's index is based on contracts signed as far back as mid to late June. Although "affordability" has played some factor in the lower number of contracts signed over the course of the summer, I have a hard time believing that anyone looking at buying a home anywhere up until late September was worried about a Government shut-down. Thus, we can completely discredit the Government shut-down excuse for the large drop in contract signings.

Instead, the drop in contract signings is indicative of a market that has peaked and is headed south - quickly, I might add. The index is declining rapidly and will likely do so going forward for the many reasons I've cited in previous Seeking Alpha posts. In fact, this particular index, according to the NAR itself, is an accurate measure of future housing market activity:

Since pending home sales measure actual existing-home sales, the PHSI provides an accurate and reliable indicator of future home sales activity. Our sample shows that over 80% of all pending home sales go to settlement within a 2-month time-period (and a significant share of the rest close in month 3 and month 4). NAR Research

That citation from the NAR website also confirms my assertion that September's number actually reflects homebuyer demand as far back as mid-June.

My point here is that the data that is being release by both the NAR and the National Association of Homebuilder's (new homes - see previous posts) shows that the market is entering what could be a painful decline. As an example, I ran across a research video which had data showing that new homes sales have declined from Q1 to Q3 in Nevada by an average of 60%. Please note that he shows us a spreadsheet from the housing market research group with actual market data. In addition, the presentation cites new homebuilder price discounting that is now occurring in the market and rising inventory levels.

While Nevada is just one data point, the Las Vegas market (or Los Angeles East, as I like to call it) was one of the extreme "bubble" areas both in the big housing bubble and in the current "mini" bubble. As such, it has been a solid statistical indicator of housing market direction. In other words, if the Las Vegas/Nevada housing market appears to declining in a significant way, it's a good bet that this is, or will soon be, a significant national trend.

Given my bearish view of the housing market, I believe that the homebuilder stocks are trading at price and market cap levels which reflect future expectations for the housing market that are excessively exuberant. As such, anyone who is long homebuilder stocks should take advantage of the multi-year rally and sell. And aggressive traders should short into any market strength. I track the new homebuilder stocks using the DJ US Home Construction Index (DJUSHB).

For anyone who wants to short the sector in general, you can either buy puts or short the SPDR S&P Homebuilders (NYSEARCA:XHB) or the iShares US Home Construction ETF (NYSEARCA:ITB). I prefer to short the individual homebuilder stocks because they offer great leverage to the market and I can analyze the fundamentals and financials of each company to determine the best candidates to short. Currently I'm short DR Horton (NYSE:DHI) and KB Home (NYSE:KBH). Please refer to my previous posts for more information specifically on those two companies and why I chose them (I linked some brief analysis on KBH).

Please keep in mind that the homebuilder sector is one of the most volatile. As such I always leave myself plenty of room to add to my short position on the likelihood that my timing is not perfect. I first recommended shorting homebuilders in January when the DJUSHB was around 515. Although it went lower then subsequently traded as high as 550, it's now at 447, down 15% from my original call and down 23% from 550. Please do your own due diligence on individual stock ideas.

Disclosure: I am short DHI, KBH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.