What the Homebuilders Are Telling Us

Includes: ITB, IYR, UDN, UUP, XHB
by: Timothy Charles

It's no secret that the housing market is weak. Sales are coming but at greatly reduced prices. Builders continue to put up the "million dollar castles" in cities nearby which has confused me. Financing is tough these days though available at much higher rates. Crude prices are lower but the price of unleaded has not completely unraveled... at least not yet. The unemployment rate has been moving higher and job creation is basically nil with my own models showing that job creation at its weakest since June of 2003. Lastly, the realtors of today look like the stockbrokers of the bubble era - they went along for the ride and now don't know what to do when the "ride" blows out a tire. So with all of these negatives in play, why are we seeing the homebuilders rally?

Now this is no ordinary rally. There have been squeezes in the past but those squeezes were isolated and not accompanied by other securities - in this current case, the greenback. The bears have been out on the dollar but moreso of late on the housing market. The reasoning behind such has merit but the homebuilders have continued to climb. One of my trader friends, who has been doing this for 30 years, often says that at market lows, the next leaders are born. We saw that in 2002 when the basic materials were the first off the lows. We saw that in the late '90s with the techs accelerating to the upside. Could 2008's low candidates, the financials and the homebuilders in this case, be the next leadership? Could they be telling us that perhaps credit conditions are now in place for housing to stop falling?

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That is a strong leap in some cases. One could say that the homebuilders and the financials were so beaten up that a bounce was inevitable. For the financials, I don't necessarily doubt that, and in using the BKX, they really have not reclaimed levels of last year. The homebuilders on the other hand, using the HGX, have reclaimed a trading range and have bottomed in a similar location to the lows of 2003. If they are truly moving up, and have seen the lows, this could market stability. The last true time that housing had stability was in 2005. The market probably was much more than stable at that point but in this case, I argue steady to rising prices. 2006/07 were periods of flat to down though the statistics won't bear that out. 2008 has been "tough" for the lack of a better word. Thus, stability has not existed for 3 years now going into year four, which is only four months away.

A while back, in trying to understand the real estate market, I did analysis of the new home sales data to the existing home sales data for the period during the late 80s into the 90s. Now I cannot find it anywhere but I do remember a few things from the research. First, the new home sales data bounced first followed by existing home sales data about 2 years later. This makes sense in many ways in that the new homes went into the existing pile and took a few years to work off in terms of inventory.

Meanwhile, homebuilding just was not strong during this period and overall inventory levels came down. Comparing that to the current period, homebuilders have been steadily cutting back on building and playing defense if you will. If the homebuilders index is correct, perhaps we are now at that point where the new homes sales data stabilizes while the existing takes a few years to work off the slack? So what we have here is one index telling us perhaps what is going to happen down the road.

Now there are a few things that actually support a rally. First, the Fed is maintaining an easy monetary policy stance - I estimate about 195bps at this point which is well off the lows of the Greenspan times during 2003 but still pretty easy when inflation and commodities are rising. In addition, long rates are not terribly high and only those with good credit are getting loans. Now one may look at this as a problem - I see it as a way to stabilize the market. If those who have good credit and 20% down to buy a home are the owners, the probabilities of foreclosing on these folk is much lower. If the foreclosures slow to a crawl, then the focus remains on the existing inventory which means that the price that it sells for, will be not at fire sale prices but rather something comparable to the given area.

Another factor to consider is the dollar. Now, I am not advocating that the dollar low is in. One can never call a low in a currency, in my opinion, for the long term. However, I am bullish on the dollar now and could see it trading another 3-5% higher from here. That means that dollar assets might be in vogue which could attract international flows into US domestic assets. If those assets include credit instruments, then the credit markets will stabilize which also creates better loan conditions for the banks and more buyers for the real estate market.

So what am I saying? I argue that the homebuilders have bottomed. But, I don't know if the actual housing market is going to rise anytime soon. The CME Housing futures have stabilized over the past few months but they are not particularly liquid so using them perhaps is not a strong support for the real estate market. My own models show that we are in the third wave down for housing right now (we had three rising ones in the earlier part of the decade). We have bounced each time for this level but the previous two times were not accompanied by the homebuilders. Thus, we have the CME futures, the homebuilders and my own indicator all at extremes or turning. The market is making a bet and that bet is that real estate is stabilizing.

Question is... is it a good bet?

Disclosure: Long the Dollar Index.

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