The Fragile Assumptions Underlying the Market
Comstock Partners, Inc.
Thursday, October 26, 2006
The current market rally is a bet on a soft landing for the economy along with a benign Fed and a stabilizing housing picture. In our view that is a bet with long odds based on dubious assumptions.
New data released in the last couple of days together with further comments from homebuilders adds to our conviction expressed in last week’s comment that the housing industry is far from a bottom and that there is a lot more pain ahead. September existing home sales dropped 1.9% from August. Existing single family home sales declined 1.6% month-to-month and 16.0% year-to-year, the largest drop in over 11 years. The median price declined 1.8% for the month and 2.5% from a year earlier. The inventory of unsold homes was at 7.3 months compared to 4.6 months in September 2005, while unsold existing homes for sale soared 35.1% year-over-year. The fact that homes for sale are still increasing even as sales continue to decline does not bode well for the industry in the period ahead.
New home sales for September rose 5.3% month-to-month after downward revisions for each of the prior three months. So far this year, preliminary numbers have been subsequently reduced by an average of 5%, and this likely to happen for September results as well. Sales were down 14% from a year earlier, and a 6.4 month supply still remains on the market. Median prices took a big hit, declining 8.4% from August and 10% from a year ago. Keep in mind, too, that the sales figures for new homes do not take cancellations into account, and these are numerous. In addition the price data doesn’t reflect non-cash discounting such as free upgrades, furniture allowances and other giveaways.
It is also noteworthy that home building industry executives, who are in a position to know, consistently deny that a bottom is close. This week Pulte CEO Richard Dugas stated that there is no bottom in the real estate market. Pulte wrote down $87.7 million of land inventory and options as new orders declined 39%. He mentioned continuing high inventory levels, low affordability and high cancellation rates. These comments were in line with statements from other industry executives that we wrote about last week.
Until recently housing industry employment has been largely contained as work continues on previously started units while employees in related activities are still busy with sales of current inventories and mortgage services. All this comes to an end when inventories are pared down and construction declines further. We’ve noted previously that some studies show that as much as 30%-to-40% of the job increases for the economic cycle is attributable to housing sales and related activities. This should have a serious impact on consumers. In addition consumers will have a lot less to spend as soaring housing prices will no longer be available as a convenient ATM machine.
As for the benign outlook of the Fed, forget about parsing every word in the FOMC statement. What does the Fed really know about the economy in the period ahead? Judging by their performance in 2000, when they were essentially clueless, they don’t know very much. In mid-November 2000 they still maintained a tightening bias as they do today. In late December, barely a little over a month later, they switched directly to an easing bias without even stopping at neutral. Then, in early January 2001, only six weeks after the mid-November tightening bias, they had to call a special interim meeting to cut the fed funds rate. The vast majority of economists did no better than the Fed.
All in all, we would be extremely cautious in assuming a stabilizing housing picture or a benign Fed leading to an economic soft landing. We would therefore be even more leery about trusting this stock market rally. As the year 2000 should have taught us, things can change in a big hurry--and the coming decline in housing has even greater implications for the economy and stocks than technology had in 2000.
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