Where We Stand
After bottoming in 2009, home prices showed strong growth through 2013, and has since cooled off slightly. Over the last 2 years, home price growth has been remarkably flat due to an interesting tug of war between supply and demand.
I look at the growth rate of housing as opposed to the nominal price of housing. For example, if home prices are growing at 10% year over year and then falls to 5% growth year over year, home prices are still going up, albeit at a slower pace. I view this as a negative, although prices are still moving upwards. Measuring housing in this fashion often allows you to front run real estate moves because the growth rate has to fall before becoming negative and waiting until the growth rate is negative (or home prices falling in nominal terms) is often to late. Studying the change in growth rate allows you to stay ahead of the curve.
Currently the growth in home prices has been very flat at around ~5% year over year. Since the growth rate is flat, this provides little insight into the direction of the next move in the real estate market. It is now even more important to understand what is causing home price growth to remain so stable.
Supply is very low, putting upward pressure on prices, while demand is weak putting downward pressure on prices; the result being home price growth that has been flat for almost 2 years.
This alone is an interesting phenomenon because the housing market moves in very long, broad cycles, much line a sine curve. Real estate prices usually hit peaks and troughs; very rarely does the housing market rest at a median level or remain stable as it is now.
The tug of war between supply and demand will snap in one direction or the other and there are many arguments for both scenarios. It is my take that due to falling personal income growth, the late stages of a credit cycle, rising interest rates and a slowing labor market that weak demand will overpower limited supply and cause real estate prices to trend downward over the next twelve to eighteen months.
Many real estate bears point to the nominal price of housing and claim we are near the 2007 bubble level, therefore there must be a real estate correction. While this is true, nominal home prices are at historic highs in some areas (depicted below), when looked at on a relative affordability basis, homes are still cheap.
The chart above shows the Case Shiller National Home Price Index which tracks a national average of nominal home prices. This graph shows that on a nominal basis, home prices are rising and have reach levels not seen since late 2006, right before the housing crisis.
As a bear of the housing market you might think I would use this to augment my case however when looked at objectively, houses are still relatively cheap. Of course, if they are cheap they can still go down as I expect but affordability is certainly not a factor that is stunting demand.
The chart below is the Housing Affordability Index as defined by the National Association of Realtors. Their data only goes back to 2013, however they publish the formula used so I recreated the data series to go farther back in time. You can find the formula here.
From National Association of Realtors:
To interpret the indices, a value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. An index above 100 signifies that family earning the median income has more than enough income to qualify for a mortgage loan on a median-priced home, assuming a 20 percent down payment. For example, a composite HAI of 120.0 means a family earning the median family income has 120% of the income necessary to qualify for a conventional loan covering 80 percent of a median-priced existing single-family home. An increase in the HAI, then, shows that this family is more able to afford the median priced home.
This chart indicates that a family with a median income has 162% of the income to qualify for a mortgage on a median priced home. Contrast that to 2006 when the index was just over 100 indicating the average family had barely enough money to qualify for the average mortgage.
This clearly shows that housing is affordable to most families and the lack of demand must be coming from other factors.
If housing is affordable, why is demand so low? The caveat to this index is interest rates. Interest rates have been at historic lows. Homes are very leveraged assets so even small changes in interest rates can drastically change the affordability of a house.
Currently homes are relatively cheap as described above, but a small jump in rates, even 1% can cause this index to tumble, even without a change in income. Incomes however are already falling so couple a rise in interest rates with falling income and this index may be painting a misleading picture as to the safety of the housing market.
Here is a chart I recreated using the same methodology as the above chart but I used several interest rate scenarios to show the change in affordability. (Again, this assumes incomes remain constant, which I do not believe they will.)
The index is calculated as median income / (Monthly Payment * 4 * 12)
Monthly Payment is calculated as :Median Home Price*.8 * (IR/12)/(1-(1/(1+IR/12)^360))
IR = Interest Rate or the average 30 year fixed mortgage rate
To calculate the change in affordability I kept all variables constant and raised the interest rate to calculate the change on affordability due to interest rates.
This may seem like a hyperbolic example but interest rates can absolutely change overnight.
A 2% jump in rates would put housing affordability at the same levels as 2007, right before the housing crisis.
The leveraged nature of the housing market lends itself to rapid changes in price. The above chart demonstrates how quickly housing can go from very affordable to unaffordable with small changes in interest rates.
If either interest rates rise or incomes fall, the housing market will become unaffordable very quickly.
Housing Supply and Demand
Supply in the housing market is near historic lows. This could be what is keeping prices artificially high because demand is weakening.
Below is a chart showing U.S. Existing Home Sale Inventory at century lows. Simple supply and demand tells us that a lack of supply must put upward pressure on prices.
If price growth is flat, and supply is very low, mathematically demand must be lackluster or else prices would have to continue to rise at an accelerating pace.
Pending Home Sales is a good indicator of future demand that we can use to gauge the true level of demand in the housing market.
Pending Home Sales, or signed contracts to purchase a home, have been falling, indicating weak demand. Pending Home Sales are a leading indicator of future housing activity because they are signed contracts but not closings. Typically, it takes 4-6 weeks after a contract is signed to close on a home so weakness in the Pending Home Sales numbers can foreshadow weakness in the future demand for houses and thus lower demand leads to lower prices.
Pending home sales have fallen off sharply since 2015 and have been recording negative year over year growth in the past several months.
Pending Home Sales can be a volatile number month to month so it is more important to focus on the trend which shows growth in Pending Home Sales falling from ~13% to 0%.
Another indicator used to measure demand in the housing market is the actual sale of New Homes.
Below is the New Home Sales Index Growth. This measures the growth of New Homes sold this month vs. the same month last year. (E.g. Number of New Homes sold in Jan 2017 vs. Jan 2016)
New Home Sales are well off their peak in 2015, growing at nearly 30% year over year to just 5% growth one month ago.It is clear supply is constrained and demand is lack luster to say the least.
Something must be accounting for the lack of demand for housing given the affordability. Next, I will look at several key metrics to gauge the health of the consumer to explain the lack of demand.
I believe the consumer will being to struggle towards the end of 2017, amplifying the demand issue, and ultimately causing real estate prices to fall at the end on 2017 and into 2018.
Strength of the Consumer & Demand
It is important to understand the financial health of the average consumer because a house is the largest purchase an individuals will make and if incomes are falling, job growth is slowing and other living expenses are rising, then the housing market will suffer.
As mentioned, my view on the coming weakness of the consumer is based on three main factors:
- Decelerating Labor Market
- Decelerating Income Growth
- Late Stages of the Credit Cycle (Banks less willing to lend)
The first metric to look at is the very popular Non-Farm Payrolls data series released on the first Friday of each month.
This data series shows the amount of jobs added (lost) during each month.
As with the housing data, looking at the nominal increase (decrease) in jobs does not tell the full story, it is more important to look at the growth rate of Job increases (decreases).
If the labor market was growing at 3% year over year and is now growing at 1.5% year over year, the labor market is less good or getting worse. This is the appropriate way to look at it. Conversely during recessions, job growth of -5% is less bad or getting better than job growth of -7%.
Looking at data in this fashion, as mentioned earlier, keeps you ahead of the headline data, and allows you to react before it becomes consensus news.
Job growth has been decelerating since the beginning of 2015. The below chart shows the growth in non-farm payrolls year over year.
Job growth has clearly rolled off its cycle peak in 2015 and has been decelerating ever since. Not to say it is impossible, but based on the last several cycles, once job growth rolls off its cycle peak, it usually does not reverse trend until the next economic cycle. There may be month to month increases in job growth but the overall trend has clearly been lower since February 2015 and this has been a fairly reliable indicator of the economic trend. If this data series continues as it has in the past, job growth will continue to trend down until it becomes negative, signaling a loss of jobs in the economy, clearly a negative for the consumer and the real estate market. This is an important indicator to watch for the general direction of the economic cycle.
Similarly the Job Openings and Labor Turnover (JOLTS) data series shows a similar picture in regards to the slow down of the labor market.
The Job Openings series indicates the amount of current listings for Job Openings in the economy. More Job Openings indicates a willingness to hire and can foreshadow the above Non-Farm Payrolls data series.
The growth rate of Job Openings is negative as of the last reporting period indicating there are less jobs available to be filled than this time last year, another negative for the labor market and thus the consumer. For context, the rate of change in job openings is near where they were during the start of the last recession and well off the highs in 2015.
From the same JOLTS data series, we can find New Hires. We measure the growth of new hires the same way as the previous data series and we can see the trend is no different.
New Hires is another volatile data series so while last month's number showed a nice pop, there is still no clear change from the downward trend that began in 2015.
New hires is a leading indicator for the labor market. Firms will typically stop hiring before they being firing employees and the chart above shows that new hire growth trending downward and even negative in a few of the last several months.
As the labor market slows and new hiring grinds to a halt, incomes begin to slow and now we are beginning to see large decelerations in personal income growth.
Personal incomes are decelerating and that clearly will put downward pressure on housing affordability and continue to suppress demand.
Personal income is very important to track because buying a new home is a marginal use of income and typically are purchased with surplus income. If incomes are falling and the cost of living is rising, or even staying the same, the consumer will have less surplus dollars to spend on marginal goods such as an upgraded home; another factor suppressing demand.
Late Stages of the Credit Cycle
The credit cycle is tremendously important in the United States and the willingness for banks to lend money can be a driving force in the direction of asset prices. As the credit cycle comes to an end, banks tighten their balance sheets and have less desire to lend. As lending falls, there are less dollars pouring into assets such as real estate, putting downward pressure on demand and prices.
A broad measure of the credit cycle is the Commercial and Industrial Loans data series that aggregates bank balance sheets and reports the assets, liabilities and loan amounts on a weekly basis.
The last several weeks has shown the most precipitous drop in loan growth since the great recession indicating banks may be tightening their lending standards at an alarming pace.
Loan growth appears to be falling off a cliff in the last several weeks.
Again, this is an overwhelming negative for marginal demand in the real estate market as banks are loaning money at a slower pace, making it more difficult to get a loan (mortgage) on a house, driving prices lower.
Right now there is a tug of war going on between a lack of supply that is putting upward pressure on housing prices and a lack of demand that is putting downward pressure on housing prices.
It is my view that due to decelerating job growth, negative rates of new hires, decelerating personal income and a credit crunch at the end of the cycle, the tug of war will reach an inflection point and result in home price depreciation.
I am using the iShares U.S. Home Construction ETF (NYSEARCA:ITB) as a proxy for my bearish view on the housing market with a time frame of 12-18 months.
The reason I am giving myself 12-18 months for this to play out is due to the slow moving nature of the housing market. Of course I reserve the right to change my opinion as the data changes but at this juncture the housing market seems to be built on a foundation of instability.
This instability is something that needs to be monitored carefully in the coming months to see if the deterioration continues or if this is merely a blip in the strength of the consumer and housing market.
There are too many negatives to ignore and the probability lies with the cycle ending over the next year.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.