Housing To Lead Again?

 |  Includes: HD, TOL
by: Dirk McCoy

Home prices go up. That used to be conventional wisdom, until the Fed unleashed 18 straight rate hikes, inverting the yield curve such that house payments doubled for some people, a rush to sell was on, and the bubble burst - first in the US, then Europe (soon, China?). As trillions in wealth evaporated, so did spending.

But conditions are now converging for a housing rebirth:

1. Interest rates are at a historic low, but are likely bottoming out and could start to rise;

2. Scott Walker's victory shows that politicians can address employee cost and survive, which in addition to facilitating budget balancing could have the odd effect of allowing more hiring (and why should class sizes be going up, anyway?);

3. Inflation in China's developed coastal cities is reducing pressure to move work there from the US, and manufacturing is seeing solid growth, although competition will remain fierce for decades as Vietnam, Indonesia, Africa, and automation exert downward pressure on China's wages;

4. As hinted at this week by Fed Vice Chair Janet Yellen, the Federal Reserve is poised to maintain low interest rates for the long term, with few signs of inflation and alternative energy options (including an end to the Obama Administration attacks on fossil fuels) alleviating concerns over Peak Energy;

5. Home prices have dropped significantly, and are starting to trend up in some places. All that is needed to solidify this is for the Presidential candidates to eschew eliminating mortgage tax deductions and deductions for real estate taxes on second homes. This will likely be a key issue in the upcoming election that neither side will want to lose;

6. Andrew Butters was quite prescient in his forecast of home prices four years ago. His prediction two years later was also correct, and shows the bottom of the housing bust being Q1 of this year.

I wrote a couple articles three years ago about confidence and mortgage modification programs in which I claimed the plans to "save" the housing market were likely going to be inadequate. Which is what has happened.

While I very much appreciate free market principals and respect the power of price signals and private property rights, I also see the serious moral dilemma in a "let em default" approach that cuts the legs out from homeowners such that the most profligate abusers skate away in bankruptcy while large amounts of real wealth are destroyed amongst those who had the largest amount of equity in their homes.

Consequently, there is solid political support, and growing economist support, for stabilizing home prices via interest rate reductions and tax policy. Hopefully the Fed has learned its lesson about bubble popping, as I haven't heard Ben Bernanke suggest it would be a good idea to raise interest rates on student loans.

And as we saw after the 1998 legislation that increased NPV of housing overnight by raising home capital gain tax exclusions and allowing them every two years, a virtuous cycle can create strong momentum.

If home prices do begin to increase at double the pace of inflation while prices for labor and materials moderate as supply capacity exceeds demand, it's possible the cost to build a new house will come closer to the cost to buy, and homebuilding will pick up. I'd look for quality homebuilders like Toll Brothers (NYSE:TOL) and suppliers like Home Depot (NYSE:HD) who don't have significant Europe or China exposure to continue their upward rise, with another 10-20% upside over the next year, along with land prices (although developments in ag technology and weather could conspire to create a glut of food that depresses farmland prices, especially premium land priced at $10K/acre or more).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.