The Housing Paradox Could Mean Further Price Erosion

by: Caleb Sevian

An interesting paradox has been developing in the housing sector over the last couple of months. In the second half of 2006 we witnessed a massive slowdown in the housing sector, caused by rising interest rates and a slowing economy. As we moved closer to the end of the year, the story began to change ever so slightly. Expectations of continued economic weakness and a Fed ease began to pressure interest rates lower, and just as this happened the economy appeared to reaccelerate.

The outcome was lower interest rates and rising economic activity giving way to wage growth. Given this scenario, it should be no surprise that towards the end of the year housing appeared to have settled, and may even have appeared to bottom. This may, however, change this month when we see the effects of January’s upward interest rate pressures and relatively cold weather.

With this as the backdrop, we are now set up for an interesting paradox: for housing to stabilize we need interest rates to fall, but the only way that interest rates will fall is if the economy deteriorates -- perhaps crimping the consumers’ ability to afford a new home. This paradox sets the stage for further home price deterioration.

As anecdotal evidence, the Case-Shiller Housing Index, which projects future home prices, is anticipating a 4% decline in housing prices by the end of the summer. Housing sector weakness has thus far been confirmed by builders’ 2007 projections.

With a little over 10% of the S&P500 having reported Q4 06 numbers, the initial assessment looks lackluster. Reuters estimates Q4 06 earnings growth to be up 8.9% from last year. This is down from Reuters' estimate of 9.4% two weeks ago. Keep in mind we just came off of a record 13 straight quarters of double digit earnings growth. Earnings growth clearly seems to be decelerating.

Although earnings are perhaps still strong enough to stoke an already hot stock market, the earnings deceleration combined with a 40 basis point jump in the 10 year Treasury (driving mortgage rates higher), gives us the formula for a weaker housing market: rising interest rates and slower economic growth. Though further housing weakness is probable, an all out selloff in housing is still highly unlikely.

As I said in my predictions for 2007 piece at the end of 2006, the most uncomfortable news this year in the housing sector is likely to come from builders laden with inventory having to adjust their supply picture to accommodate a moderating demand level.