The latest new home sales reports offers both hopeful optimism, and some much-deserved criticism. The Census Bureau estimates of new home sales in previous months have already seen some significant revisions to the downside. That's because cancellation rates with the home builders are once again drawing scrutiny as interest rates rise. The continued decline in mortgage purchase applications is telling us that homes are simply not affordable for many traditional buyers. Thus, it's no surprise that the headline gain in September and October new home sales came courtesy of a 5.3% drop in median prices. The recent jump in the 10-Year Treasury yield tells us that things could get worse for the home builders.
Going forward, the cancellation rates with the home builders will be important to watch. More results exposing shrinking net sales could become the norm. In their Q4 results, DR Horton (NYSE:DHI) played up the fact that average home prices were well ahead of last year, even though they saw a drop in sales volume and a 31% increase in contract cancellations. The Q4 results gave DR Horton a fiscal year decrease of 2% in net homes sold. Stop, and let that sink in for a moment, because it tells you a lot about what's happening in the U.S. residential real estate sector. Looking at a chart of the Housing Sector Index (HGX) or the Home Construction Index (DJUSHB) it's clear that home builders have struggled to maintain momentum from the recent "recovery." A number of the home builder stocks have actually underperformed the indexes this year. National builders like DR Horton, Beazer (NYSE:BZH) Lennar (NYSE:LEN), KB Home (NYSE:KBH), and Pulte (NYSE:PHM) are likely finding the current environment of high land prices and escalating labor and lumber costs a bit more challenging than they anticipated.
The inflationary environment in U.S. residential real estate will likely provide little comfort to the home builders heading into next year. Traditional buyers are already tapped out with recently inflated home prices, rising mortgage rates and shrinking savings due to the Fed's disastrous experiment with quantitative easing. The stewards of our economic ship, the same ones who missed the last bubble blowing up in their faces, are now at the helm of even more bubbles, and no good alternatives to address them. The rising tide experienced in many U.S. home markets this year could easily turn into stormy seas next year.
Markets like Houston, where the real estate sector is still riding the coattails of a parabolic rise in oil production, will be the exception, not the norm. Even stronger markets like Houston are likely to experience some weakness in the housing sector next year. The Goldilocks sellers' market in the Bayou City is already starting to backfire. While average days on market were down to less than a month during the peak of activity this summer, the wind is now shifting, and days on market are now beginning to creep higher. For several consecutive months, average selling times have increased, and this is not just your typical seasonal shift. This has occurred while home prices have been reaching record highs and inventory has hit all-time lows. Irrational exuberance is approaching a head-on collision with home affordability.
Today's markets are priced for perfection and the endless supply of free money we've been enjoying courtesy of the Fed. The stocks of the home builders have been primary beneficiaries of a host of stimuli and incentives in the real estate industry. Contrary to what your local real estate board might be telling you, local and national housing markets have not recovered because of organic, fundamental supply and demand. That's why I recently added a new page to my site to help people understand what's driving Houston's latest housing boom. As you can see from the latest chart of Fed assets, 2013 was a banner year for the Fed. They were almost as active this year as in 2009 when the liquidity injection frenzy first started to levitate markets and asset prices.
Wall Street's new rental empire won't provide a sustainable market for the home builders, because investors aren't stupid enough to pay today's inflated prices for new homes. That leaves traditional buyers to fill the void, and there simply are not enough of them to keep the housing recovery intact, not when real wages and average family incomes are still getting pinched and household formation is stuck in the mud.
As we head into 2014, U.S. housing markets will face a number of challenges. In Houston, like many other areas of the country, a prime concern will be high prices and thin inventory. Abnormally low inventory has been one of the saving graces of the home builders, but this false market phenomena is already shifting in many major U.S. markets as existing home inventory begins to rise. A small supply of existing home inventory has been a big reason new home builders have been able to justify higher prices. Now that real market forces are coming into play and more existing homes hit the market, home builders are going to get pinched competing for a stagnant pool of potential buyers.
The latest housing bubble may grow bigger. Bubbles can defy logic longer than we often imagine. That being said, It looks pretty clear to me that shifting macro forces and increasing scrutiny of the Federal Reserve's failed trickle-down monetary experiment will put a lid on further home price increases in most U.S. real estate markets, and that will make things tougher for the home builders as margins get compressed even further. Traditional home buyers are already getting sticker shock in many U.S. real estate markets, and unless the Fed ramps up the printing press to a whole new level of insanity, it stands to reason that real estate and equity prices could experience a sizeable hangover in 2014. I would look to short home builders on any continued strength. Just like many other facets of our economy, the housing "recovery" is not what it seems.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.