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Markets: Housing Hemorrhage
New York: September 04, 2006
By John R. Stephenson

"I've never seen a soft-landing in 53 years, so we have a ways to go before this levels out. I have to prepare the company for the worst that can happen."

--Angelo Mozilo, CEO of Countrywide (the largest independent mortgage lender in the U.S.)

The news isn't very good. House prices, which represent some 48.5% of U.S. household wealth, appear to be sliding with no end in sight. On the Chicago Mercantile Exchange (CME), where traders bet on the future prices of homes across the country, this market is currently pricing in a slide of 5% in the value of house prices next year. In some parts of the country, the inventory of homes for sale (number of homes for sale divided by average monthly sales) is over seven months long. This is translating into lower house prices as sellers become discouraged and poor results for the nation's homebuilders.

Veterans of the home building business, such as Mr. Toll, of Toll Brothers Inc. (TOL-NYSE) are stumped. According to Toll, in his 40 years as a home builder, he has never seen a slump unfold like the current one, where "you've got low unemployment, you've got a stable stock market and relatively low interest rates." And yet, it's happening with some regions of the country reporting new home sales declines as much as 30% relative to a year ago. In fact, the value of the shares of the homebuilders listed on the New York Stock Exchange (NYSE) has fallen by almost 50% versus a year ago.

Making matters worse, is the fact that while unemployment rates may be low, wage growth has been largely stagnant across the country. Because of this, homeowners have relied on the inflated values of their homes to fund their latest purchases. With real residential investment down 6.4% last quarter, house prices are starting to fall and consequently home equity withdrawals are beginning to slow.

As well, some 30% of the employment growth in the U.S. over the last three years was from the housing sector. Jobs were created in construction, real estate broking, mortgage finance and building materials. With house prices starting to fall, this has broad implications for the economy at large.

Sales of consumer durables (items such as home appliances and furniture), have already started to fall across the U.S. As well, the wealth tied up in people's homes is far more broadly held than the wealth that individuals held in NASDAQ shares (a predominately technology weighed index) in 2000 making a sharp downturn in housing a far worse problem for the economy and the stock market in general.

Figure 1: Could a Housing Slump Sink the Stock Market? NAHB Housing Market Index & S&P 500, 1996-2006

Recent research from Global Insight, an economics firm, seems to suggest (Figure 1) a strong linkage between the housing market and the stock market (lagged). What they found was that what is good for the housing market is good for the stock market and vice versa. While some concerns have been raised about the analytical methods employed by Global Insight, namely that the National Association of Home Builders (NAHB) index is not a measure of house prices but rather an index that measures sentiment (from 0% = poor to 100% = good) for the new home construction industry.

Nonetheless, the conclusions of Global Insight seem logical. In the wake of several moves to raise interest rates by the U.S. Federal Reserve (from 1.0% to 5.25%), consumers with limited wage growth and higher mortgage payments are finding it a stretch to keep making their monthly payments. The solution? Put your house on the market at the top of the market and hope to get out. The problem? Other people seem to have figured this out and everyone appears to be rushing for the exits setting house prices on a downward path.

The stock market faces a challenging future if house prices continue to tumble. That's because housing has been such a key component of the overall U.S. economic growth. The shares of homebuilders, appliance makers, auto industry and most firms that are dependent on the U.S. consumer are going to face increasingly difficult times as consumers who at the very least will feel poorer (the wealth effect) will be increasingly reluctant to spend.

For investors, caution is key. We continue to favor investment in base metals producers, oil and gas firms and companies with a long record of maintaining or better yet increasing their dividends. Companies with a high level of dividend payout should form an integral part of an all-weather portfolio since every year you are getting a return on your hard earned investment capital.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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