Why Builders Are Trading UP

Home builders trade up (!) today. What's up? Two things:

1) builders are DOWN 30 to 40 percent in the last two months, and

2) with these kinds of sales, builders will build even less, and inventory will come down even more.

Still, the numbers were a shock. The May new home sales number, at 300,000, is an all-time low (they started collecting new home sales in 1963). The number was 30 percent below analyst consensus of 430,000. April new home sales, which included the benefits of the tax credit, was also revised downward by 58,000; March was also revised downward.

The inventory of new homes for sale went to 8.5 months from 5.8 in April, the highest since June '09.

Is this a bottom? The problem here is that mortgage application volumes for May have been poor, suggesting more weak numbers for June, even though mortgage rates are well below 5 percent.

Despite the poor showing, many analysts remain moderately optimistic about future sales:

1) Barclays: "We expect new home sales to bottom over the next couple of months and to return to a gradual upward trend thereafter."

2) Deutsche Bank: "While these numbers were terrible, we remain more sanguine on the economic outlook than the consensus."

3) Morgan Stanley: "...underlying fundamentals should support improvement in home sales in the second half."

The main argument of the bulls is that it will take very little increase in sales to create new production. Right now, there are only 213,000 new homes for sale (a 40-year low!), and about 3.9 million existing homes for sale.

That's true: we are set up for a bounce. But will we get the income and job growth to do it?

More Analysts Speak - Optimistically

Analysts Remain Upbeat

More analysts remain upbeat about a housing turnaround — just in the last few hours a half-dozen analysts have made supportive comments of the future homebuilding turnaround:

1) Ticonderoga: "...we do not believe such a low level of sales is the new market reality and would expect a slow, gradual climb upward as we move toward the fall....this week is the nadir for bad news flow from the housing sector."

2) Soleil: "We continue to anticipate the housing recovery to see more sustained improvement in 2011, with local and regional sub-market dynamics increasingly becoming key drivers."

3) UBS: "home sales should begin to recover in coming months with further job market improvement"

Regardless: the bulls on housing are very much on the ropes today. Certain assumptions, like low levels of homes for sale must lead to lower inventories, are clearly being questioned.

1) There is still a significant inventory to work off. There is an argument that building has not kept up with household formation, and will soon bounce back. But there is a hole in this argument. True, we need about 1.7 million total homes constructed every year (1.3 million new households plus 400,000 for replacement and second homes), but as real estate analyst John Burns has noted, we exceeded this for 5 consecutive years from 2002 to 2007; we still have 2 million more vacant homes than we need.

2) Household formations have been way below normal because of the lack of job growth; instead of 1.3 million new formations last year, we had roughly 400,000 and may see only slightly better numbers this year.

3) L-shaped recoveries can last a long time. In local markets that were dramatically overbuilt, it took more than a couple years to recover full demand. Burns notes that Houston's 1983 oversupply downturn lasted 9 years; southern California's early 1990s homebuilding downturn lasted 8 years.

4) the shadow inventory is very difficult to quantify but may be very high. We don't know how much hidden inventory is out there, but Burns estimates there could be 5 million homes; many observors have said that a large percentage of the loan modifications done in the past year will likely also end up on the foreclosure list.

Are there any positives? Yes: Burns notes that owning is now cheaper than renting in many markets.

In Sacramento, for example, homeownership is $44 per month cheaper than renting.

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