- Housing recovery has been led by artificial stimulus, without necessary structural reforms.
- Affordability of single family homes has diminished significantly.
- Builder sales contracts and home builder confidence are stagnating.
The Housing Sector Index (HGX) and Home Construction Index (DJUSHB) suffered another setback this month. Major U.S. home builders were repeatedly citing bad weather for lower-than-expected home sales to start the first quarter of 2014. While housing apologists and market cheerleaders were suggesting that the slowdown in housing was only a temporary blip, once you start digging beneath the surface it becomes glaringly obvious that the U.S. real estate sector is still on life support. K. Hovnanian (NYSE:HOV) proved as much a few weeks ago when it reported lower than expected earnings on poor sales volume. The market punished the stock to the tune of over 15 percent, and most of the other national home builders dropped in kind as the lofty expectations of a breakout in the housing stocks were capped once again.
The failure of the home builders to establish a long-term breakout to the upside should not be surprising. The fact is, our largest banks have been using fraud as a business model for years now. The fact that none of the executives running these institutions have gone to jail yet does not change that reality. Thus, it should come as no surprise that mortgage lending has suffered as this fake recovery plays out. The problems in the housing sector go well beyond cold weather or tight credit.
What's playing out in the housing sector is the moral hazard of throwing piles of money at a corrupt financial system without any structural reforms or accountability. The recently released Inspector General's report on mortgage fraud only touches on a small section of the actual mortgage fraud, which has been ongoing at America's largest banks. This is something Chris Whalen touched on when he suggested that fraud is now the business model of our large banks.
All of the national home builders are now dealing with a similar problem, diminished affordability in a largely fake recovery. Depressed sales figures to start the year were not caused by cold weather (at least not entirely). The real problem plaguing the housing market is that homes have become too expensive for many prospective purchasers. Those lofty home prices have placed a lot of buyers in a difficult proposition. Should they jump into faux economy with both feet and buy an expensive house, or should they wait it out?
For some, the buying decision has already been made for them because the qualification ratios for a mortgage have already been breached, as witnessed by the declining percentage of first-time home buyers, which dipped to 26 percent in January. That's the catch-22 the Fed has put itself in by artificially juicing home prices and stocks. As professor of real estate finance, Anthony Sanders has noted recently, the incomes of most Americans have remained stuck in the mud during the Fed's epic bout of asset inflation. Average earnings and mortgage purchase applications have been stuck in "death valley" for one simple reason. The trickle down experiment in monetary policy isn't helping the real economy. It is, however, creating an interesting situation akin to "The Truman Show."
Our new warped, manipulated markets are a fiction of the Fed and housing policies, which have bolstered the oft-repeated "recovery" theme. Unfortunately, reality is a bit different for real Americans living on real stagnating paychecks. When you throw in stagnating wages with higher home prices and rising interest rates, it's no surprise the home builders' sales contracts have suffered. The "growing gap between the financial markets and the real economy" has created a fake market. This is what Seth Klarman was referring to when he referenced "The Truman Show" economy:
"Every Truman under Bernanke's dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they're sure everyone else won't stay on forever."
This is also the real estate market we find ourselves in these days, and the home builders are grappling with that reality with every subsequent move up in 10-year Treasury yields. The reason is simple. The real estate sector is still on life support, and rising rates will most certainly put a dent in the sales of already expensive homes. All national home builders are going to be affected by this predicament. K Hovnanian was hit harder than most due to a weak report. KB Home (NYSE:KBH), Pulte (NYSE:PHM), Lennar (NYSE:LEN), D.R. Horton (NYSE:DHI), and Toll Brothers (NYSE:TOL) have also seen recent pullbacks in their share prices.
A real breakout in the home builder stocks will continue to prove elusive until the structural problems within the markets and the economy are addressed. I don't see that happening anytime soon, and that's why I don't have any money in this market. A more rational play might be to just play the ups and downs with the knowledge that sustained momentum in the housing stocks will be difficult without more stimulus from the Fed.
As a real estate professional in the single family space, I am careful to point out to clients that this market is both irrational and abnormal. There will be a lot of properties in this market which don't sell, and that's because they are simply too expensive for what they are. I see the same problem facing home builders, which have been feasting on the Fed's bounty of artificial stimulus. As the stimulus wanes, home builders will have two choices as I see it. They can either lower their expectations on pricing and margins to capture more sales, or they can lose market share to another builder that does.
For those home builders who haven't been paying attention, they might want to clue in to the fact that U.S. household formations have gone negative. Yep, that's right, the momentum household formation and pent-up demand story is a load of rubbish. Average consumers are tapped out in terms of disposable income and maxed out in terms of the debt burden they are already carrying. And we wonder why mortgage purchase applications have been stuck in the mud? First-time home buyers aren't capable of stimulating the market to any reasonable degree given the current environment of high home prices and rising interest rates.
With some $221 billion of HELOC loans poised to reset over the next 4 years, a lot of current homeowners may find themselves feeling a little less wealthy as well. For now, the strategy for many of those with the means to do so is to park some of their wealth in real estate. As Bloomberg reports, the savings plan for many in the U.S. has been a strategy of buying an expensive home. Only time will tell how much longer this plan remains viable. A closer look at the numbers suggests that the Fed's "Truman Show" real estate market appears to be weakening. Home builders are likely to maintain their optimistic outlook for future growth, but my instincts tell me they're going to need some help before that growth materializes. Building more apartments isn't exactly my idea of progress.
This week, the National Association of Home Builders confidence index rose a scant point to 47. Housing starts disappointed again this week because reality is coming home to roost. Single-family home starts stagnated, while single-family permits actually fell 1.8 percent. The only thing propping up the headline number on construction was multi-family. Welcome to the "Truman Show" housing recovery!