Here’s The Double Whammy That Will Crash The Housing Industry

Yesterday we looked at a few of the signs of impending doom in the US housing market. Today, we’ll dig a little deeper into the data for a few, more revealing, morsels that reveal a double whammy that will crush the housing industry and homebuilding stocks.

I’ll also follow up on a recommendation I made back in October to take advantage of this setup. Is it still a short? Can we get in now? Get out, or hold?

Let’s take a look and I’ll give you the answers.

A Deeper Dive Reveals More Signs of Tightening

When mortgage rates began to rise in 2016, sales kept perking along. We know this is human nature. When interest rates being rising, fence sitters who have been dallying purchases are motivated to get moving. They worry about rates going higher, so they buy now rather than wait longer.

This dynamic works in all industries, but it is particularly acute in housing. Not only do I recognize this from having studied the data for years, I know it from my personal experience in the real estate business. Rising rates are initially stimulative.

Eventually they do take a toll on demand because reduced affordability causes buyers to either lower their price offers, or drop out of the market altogether. The sharper than usual seasonal drop in prices in the second half of 2018 that I reported yesterday is just one sign of a market that is weakening because of that.

The drop in sale closings is another sign. And it has been dramatic.

Drop In Closings Shows Affordability Is Not The Only Issue

The first rise in mortgage rates in late 2013 didn’t slow sales at all. December 2013 sales were up 3.5% from December 2012. Rates then declined until mid 2016 and the housing market continued to heat up, with growing sales volume, despite complaints of tight inventory. Price inflation was strong, hanging around 6-7%.

When rates started rising again in November and December 2016, there was virtually no impact on sales. They didn’t grow, but they were already at red hot levels. Sales in December 2016 were virtually unchanged from December 2015 at 437,000 units. That was the highest December sales total of the entire rebound from the housing crash. The average 30 year mortgage rate was 4.2%.

The mortgage rate was a little lower in 2017, but prices were 5.7% higher. That was on top of 4.5% inflation in December 2016, and 7.2% in December 2015. Even though mortgage rates hadn’t risen, monthly payments had. That took a toll on the market.

As I’m sure you are aware, average wages were not keeping pace. They were growing at less than 2% per year during that period. So sales softened. They fell by 2.3% year to year.

Mortgage rates broke out to a new 4 year high in February and continued rising until November when they reached nearly 5%. That took a toll. Sales closings plunged 11.7% year to year. It was the worst performance since the housing crash 10 years before.

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The sharp drop in closings wasn’t merely a factor of lower sales. More deals were falling through, or being delayed. There was an increase in contracts that never made it to closing.

This signals that not only is affordability crimping demand, but also that lenders are tightening underwriting standards. They are looking more closely at borrowers’ income and credit ratings. And as price inflation begins to reverse, appraisers are starting to rein in the market factors that they use to inflate their appraisal values.

You can see that in this chart. Over the past year, closings have fallen faster than contracts. Lenders are doing the Tighten Up. Once that process starts, it typically feeds on itself and creates a negative feedback loop in the market.

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The observations I draw from this data are not theoretical suppositions. I worked for 2 years in the real estate sales business and 19 years in the mortgage and appraisal businesses. I’ve experienced these processes first hand. As a real estate broker and mortgage broker I pushed hard to get deals closed as markets began to tighten. Once the cycle had peaked, formerly easy underwriters and appraisers pushed back.

Later in my career, I was a commercial real estate appraiser for 15 years. When market conditions weakened, I was among the first to recognize those changes, and my appraisals reflected that. Clients, who wanted to close deals, were not happy with me, but I had to call it as I saw it.

As a result, as the S&L crisis exploded in the late 80s and early 90s, I got a lot of work from the FDIC and RTC, the government agency set up to resolve failed S&Ls. I saw the results of inflated appraisals, and too easy, often fraudulent, credit standards for commercial, industrial, and residential projects.

One of the most fraudulent failed projects I appraised for the lender in possession had been developed by the current President of the United States. The units in that building were subsequently sold over several years at a fraction of their original asking prices.

I was integrally involved at both the end of that bubble, the collapse, and the recovery that followed. I saw it all first hand.

And I’m seeing it again today, only perhaps worse. That’s because in the current milieu mortgage rates were artificially driven far lower, and prices thus became far more inflated, than they were in both in the 1980s, and in the housing bubble of 2000-2006. Following the experience of the 1980s, I saw house prices drop by 35% in my Florida market. I bought a house at the bottom of that debacle in 1991, and sold it at the top of the more recent bubble in June 2005.

Today, prices now can only stay where they are if mortgage rates stabilize. The Fed has awakened to that fact. It has paused rate increases and when the stock market sold off in the fourth quarter money poured into the bond market. That drove government bond yields down, and mortgage rates went with them.

But this pullback is temporary. The Federal government has reduced its borrowing during the government shutdown (GSD), but it will be back in a big way, when the GSD ends. Meanwhile, the Fed continues to pull $50 billion per month out of the banking system. Sooner or later push will come to shove and bond yields will resume rising again and mortgage rates will rise with them. It will be a catastrophe for housing, where affordability is already crimping sales.

Prices will come down, homebuilders will start losing money in obscene amounts. Profits will turn to big losses. Today’s apparently low PE ratios will suddenly go to infinity. Look, I’m a chartist. I haven’t looked at builders’ balance sheets to see which ones are strong enough to survive the next shakeout.  But many will not. On a fundamental basis, I believe that the homebuilders’ ETF, symbol ITB, which I recommended back in October is still a short.

That said, we must respect the technical picture. A trading range has set up on the chart (see below). A good short entry would be near the top of that range (33.67). But if ITB breaks out above that range, we’d have to cover our short position. Likewise when it drops to the bottom of that range, it would be a good idea to cover and take profits by selling half the position. Cover the rest on a breakdown to the next major support level around 25.60 or if there’s a recovery more than halfway up in the range on this chart, which would be around 31.

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We can always reshort later, if it looks like another downleg is coming.

Do this only if you are familiar with and comfortable with chart trading on your own. If you’re not, one of my colleague Tom Gentile’s research services can help you find potentially profitable trading setups every week regardless of market direction. Check it out!

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