A House Divided Against Itself

 | Jan 28, 2013 | 11:30 AM EST  | Comments
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This commentary originally appeared at 8:38 a.m. EST on Jan. 28 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

We're beginning to hear noises that we've reached a major turning point in the housing market -- and that, with interest rates so low, this is a rare opportunity to buy. But are such observations on target?

It would be comforting if they were. Yet the unfortunate truth is that the tea leaves don't clearly suggest any particular path for prices, either up or down....

The bottom line for potential home buyers or sellers is probably this: Don't do anything dramatic or difficult. There is too much uncertainty to justify any aggressive speculative moves right now. If you have personal reasons for getting into or out of the housing market, go ahead. Otherwise, don't stay up worrying about home prices any more than you do about stock prices.

I can't offer any clearer picture, and I don't see a solid basis for anyone else to do so, either.

-- Dr. Robert Shiller, "A New Housing Boom? Don't Count on It," The New York Times (Jan. 26, 2013)

  • A real estate recovery is under way (led by multi-family starts), but a full-blown housing recovery is probably a few years away.
  • A 2013-2014 recovery in the housing market (and for the consumer in general) will be impeded by the fiscal drag of higher individual tax rates and lower government spending and possibly by higher interest rates.
  • Construction activity represents a relatively small fraction of GDP -- its aggregate impact on domestic economic growth is being overstated by many.

Today there is an almost unanimous view (from John Paulson to nearly every other hedge-hogger and talking head) that the strength in housing will be the most important factor (or one of the more important factors) in offsetting the fiscal drag associated with the spending cuts and tax rate increases (necessary to pare down the burgeoning U.S. budget).

To many, a booming housing market seems to be an almost single justification for ambitious economic growth targets and for an enthusiastic view of the U.S. stock market.

Optimism surrounding the housing market wasn't the case 18 months ago -- indeed, back then there was a great deal of skepticism (that I didn't share).

Over the past year and a half I have consistently made the case that the housing market's upside would surprise most investors over the near term and that the U.S. residential market is likely to embark upon a durable and multiyear recovery.

The key points I made in my prior analysis were that the benefits of historically low mortgage rates, vastly improved home affordability and pent-up demand (once the U.S. economy and jobs market stabilized) would yield higher home prices and rising sales turnover. Some of these factors remain in force, but other depressing factors have been introduced that could produce a halting consumer, uneven housing activity and less certain home pricing over the course of 2013.

While I remain of the view that a durable housing recovery is in place, I am less optimistic about the next 12 to 15 months.

As Yale's Bob Shiller cautioned this weekend's New York Times and as Barron's' Alan Abelson chronicled over the weekend, the housing recovery may not be steady in progress, smooth in growth and uninterrupted in its trajectory.

The fact is that housing as a series (in activity and prices), more often than not, exhibits volatility -- even when it's on the way toward recovery.

In early 2013 the U.S. consumer faces uncommon hurdles that could adversely impact the housing markets and lead to disappointing personal consumption trends.

Specifically, given the backdrop of higher individual tax rates, reduced government spending, a possible trend toward higher interest rates and a still-chastened single-family homebuyer (who has recently faced an unprecedented 30% drop in home prices), I do not anticipate a smooth recovery in housing over the next 12-18 months in the face of these macro and consumer headwinds.

Multifamily housing is seeing the biggest growth; the housing start numbers from last week were misleading. Skewed data in the housing recovery is hiding the true problem -- too many multifamily homes, single homes won't see much of a bump unless first-time homebuyers get higher income. The point is that a drop in mortgage rates produced meager results, and we can't expect more stimulus money from the Fed to keep the number positive. Too much inventory of multifamily households is going to have an interesting effect on rents -- lots of competition will force rent prices to stay low; investors won't see a lot of return....

In other words, what this still appears to be is a stimulus-induced bounce that can only be replicated in 2013 if (1) rates drop 0.75% to 1.00% below the average 2012 rate (i.e., 2.25% to 2.50% on a 30-year mortgage); (2) rates stay the same, and foreclosures and short sales surge (comes at the expense of prices); (3) exotic loan programs not requiring income or asset verification quickly become the norm; and (4) employment and income levels surge.

-- Mark Hanson

As Mark Hanson points out, the single-family housing market lacks durable leadership -- repeat buyers are carrying the housing market. The more important first-time homebuyers "are out of fire power" and peaked in May 2012, investor buyers peaked in June 2012, and all-cash existing sales volume turned flat in December 2012.

I worry that the Fed's (non-duplicable) stimulus (ZIRP), which induced a housing recovery over the past 18 months, might have even pushed forward home activity and demand and could conceivably produce a 2013 hangover -- much like Cash for Clunkers , the Homebuyer Tax Credit (which led to outsized market strength in second half of 2009/first half of 2010) or any of the other one-time fiscal policy moves designed to take the economy out of the Great Decession of 2007-2009.

Even if housing continues to recover and exhibits something more than a stimulus-related bounce, it would take a hell of a rise in construction activity to impact aggregate U.S. economic growth given construction's relatively small role in GDP. For illustration purposes, let's presume the consensus is correct and that the residential housing market will continue to exhibit strong growth. Construction represents only about 3% of GDP. Therefore a 20% increase in construction activity will only positively impact GDP by 0.6% (before the multiplier effect takes hold). This compares against a likely 1%-2% headwind from spending cuts and higher taxes (I am user a larger multiplier than most.)

Bottom line: The future outlook (in both home sales activity and for home prices) is principally a function of three variables (and I hold to a less-than-optimistic view of all these factors).

  1. Economic conditions: Strength in the domestic economy, wage growth and the status of the jobs market are the historic pillars of the housing market. I am less sanguine than most regarding these variables.
  2. Credit conditions: The availability of mortgage credit and the level of interest rates are also important ingredients to the health of housing. A further rise in interest rates could grind purchase and refinancing applications to a crawl (as housing demand has been pushed forward), even though mortgage rates are low by historic standards.
  3. The propensity for home ownership: The desire to own vs. rent is cyclical. The pendulum has swung from the speculation of the last cycle, in which homes were daytraded, to a more conservative view of home ownership (likely to be with us for several more years).

These three categories are not setting up to provide steady growth in the U.S. housing market over the near term -- there are numerous question marks.

Economic Conditions

My baseline expectation is for (at best) 1.5% real GDP growth in 2013 -- this is below consensus expectations. And I believe there is further risk to the downside.

I remain particularly cautious on the consumer (and homebuyer), who, despite a slightly improving jobs market, faces numerous headwinds.

Credit Conditions

In the last week the yield on the 10-year U.S. note rose from 1.82% to 1.95%. The consensus appears to be that the 10-year will rise no higher in yield than 2.25%-2.50% in 2013-- based in part on continued deleveraging, slow growth and a friendly Fed (which will effectively repress long rates). Homebuyers have become accustomed to low mortgage rates, but I would caution that given housing's historic rate sensitivity, any rise in interest rates above consensus expectations could immediately provide a headwind to the U.S. housing market. Indeed, I expect refinancing and purchase applications to suffer in the near term if rates continue last week's rise.

The Propensity to Own a Home

It is different this time -- the average middle-class U.S. consumer is beaten up.

Faced with two large stock market drawdowns in the last decade, a flash crash, screwflation (in which income has not kept pace with the costs of necessities of life: insurance, education, food, etc.), the largest economic recession since the Great Depression, continued jobs insecurity and a 30% drop in home prices, consumer behavior has changed and is not likely to revert to the historical spending patterns exhibited in the last few cycles.

A very good example of this is the evidence that individuals failed to purchase domestic equities until January 2013, as buying stocks took a backseat to making ends meet. As it relates to housing, the stunning drop in home prices in 2007-2010 will probably continue to be associated with a more conservative view toward home ownership and with a greater desire to rent. This helps to explain the continued lackluster single-family home market.

We can see this phenomenon demonstrated in the continuing dominance of multifamily starts relative to single-family starts throughout 2012. It will be interesting to see how the enormous supply of apartments will impact rents and home prices in the coming year.


Source: Mark Hanson

Summary

In summary, while a real estate recovery is under way, a full-blown housing recovery is probably a few years away.

I can see several factors (fiscal drag and higher interest rates) negatively impacting the consumer and serving to cause unevenness or even a pothole in the current housing recovery.

The housing market will not save the U.S. economy, and growing optimistic expectations for the residential real estate market are not likely to be met in 2013-2014.

Even if I am understating the recovery in housing, construction activity represents a relatively small fraction (3%) of GDP, and, as such its aggregate impact on domestic economic growth is probably being overstated by many.

 

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