Believe it or not, all of the officials at the Fed are not quite as blind as Bubble Blowing Ben. The Dallas Fed, run by our hands-down favorite Fed President Richard Fisher, publishes a regular Economic Letter that is always insightful and lacks the bias of certain other elected officials whose Helicopters will remain nameless. We’d recommend those expecting a strong rebound in housing anytime soon to take a look at the December 2010 issue titled The Fallacy of a Pain-Free Path to a Healthy Housing Market. Mean reversion is a powerful force in finance and a picture is worth a thousand words.
As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85 percent to their highest level in August 2006. They have since declined 33 percent, falling short of most predictions for a cumulative correction of at least 40 percent. In fact, home prices still must fall 23 percent if they are to revert to their long-term mean.
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With this picture in mind, we were particularly interested in another report recently issued by the Joint Center for Housing Studies of Harvard University, titled A New Decade of Growth for Remodeling. While the authors of the report are mildly bullish on the outlook for home improvement, we find it exceptionally difficult to get remotely excited about the industry, when comparing the chart above, to the one below. The bottom line is simple – further declines in home prices, a near certainty based on a multitude of factors, portends further weakness in home improvement and remodeling spending.
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We’ve come across several other reports on the industry with a modest bullish bias based upon a handful of arguments (some better than others). We consider many of these factors potential positives for the likes of Home Depot (HD) and Lowe's (LOW), but find little to get excited about with respect to more niche players in the industry (LL). For example, one analyst points to the fact that a greater portion of home improvement spending is non-discretionary maintenance and repair versus more discretionary remodeling expenditures. “If a window breaks, it needs to be fixed; snow needs to be shoveled and leaves need to be raked.” We wonder how many floors “break” as homes age? This trend towards “needs” and away from “wants” bodes favorably for HD/LOW relative to LL.
“The Street” also correctly identifies that ticket trends have been supported by small project spending. Importantly, home prices are a key link to ticket trends since excess home equity has been a key source of larger project related spending (i.e. flooring). The year-over-year change in HD and LOW average ticket has exhibited a close correlation (the r-squared since 2002 has been 0.78) to home price changes. However, with most analysts modeling only a “modest” further decline in home prices, we think the downside in the industry is significant, should prices fall further toward the long term average. Again, we encourage you to read the full report from the Dallas Fed (link above) to understand the multitude of factors which make a greater decline in housing our base case. In any event, we would argue that even the “bullish” outlook on small project spending is yet another potential positive for HD/LOW, but it does little for those companies in the space focused solely on flooring (LL). Flooring is quite a large ticket, particularly when discretionary income is increasingly soaked up at the gas pump.
But at the end of the day, we see more downside risk from these levels, particularly for more speculative stocks in the space (LL) that are priced for perfection:
- Historically, there has been a close correlation between mortgage rates and housing turnover. Compliments of QE2, potential home buyers are unlikely to come out of the woodworks given the spike in mortgage rates since last summer. Less turnover means less home improvement spending as the lion’s share of dollars in the space are spent by homeowners within their first two years of ownership.
- Homeownership rates and the number of homeowners have declined. Those rates are likely to continue their descent given demographic constraints and the threat of much higher interest rates in the years ahead. The upward trend in home improvement spending in the decade leading up to the bubble was largely driven by reckless domestic policy which encouraged homeownership at any cost. Since homeowners spend more on improvements than renters, the reversal of this trend should turn this tailwind into a formidable headwind until homeownership levels revert back to more normal levels.
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- Spending on home improvement has been fairly concentrated among a relatively small number of metropolitan areas, with the top 35 markets accounting for nearly 55% of all spending. It turns out that bubbly house prices have been a key determinant of these expenditures. As the housing bust and subsequent recession have been more severe in these markets (you know who you are), unemployment is likely to linger at structurally higher levels, while a greater percentage of homeowners are underwater on their mortgages. Let’s just say the largest spenders on home improvement are not exactly running out to dump more money into homes worth less that what they owe and still falling in value.
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We discussed the risks of potenital dumping duties on Chinese imported engineered flooring in our original report, titled Got Wood?. We encourage those invested in the flooring industry to take a close look at this analysis. The risk is real, despite being underappreciated on “the street” and downplayed by management. Given the potential combination of housing headwinds and potent protectionism, we wonder who exactly is buying shares of LL near 30x earnings. For what it’s worth, it would seem that at least one other shareholder agrees with our assessment – Chairman and Founder, Tom Sullivan, has sold approximately 75% of his ownership stake since going public in 2007. As another pioneer in the industry would say, “Haauh?“
Disclosure: At the time of publication, the author was short Lumber Liquidators (LL), although positions may change at any time.
Disclosure: I am short LL.