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Market Comment

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It's Still About Housing

Fri, May 29 2009, 05:52 GMT
by Comstock Partners Team

Comstock Partners Inc.

It's springtime and once again the prognosticators are trumpeting the end of the housing problems. While it does seems likely that both new and existing home sales are bumping along the bottom, it appears to us that there is still a lot of trouble ahead with negative consequences for financial institutions and the broader economy. This is far from the first time we have disputed the consensus on the housing market, and we have clearly been right. Please see our archives for December 22, 2005 ("Softening Housing Market Puts Global Economy at Risk"), October 19, 2006 ("Housing Stability? Don't Believe it"), February 22, 2007 (Unraveling Housing Market is the Key") and July 17, 2008 ("It's All about Housing"). Also, see the "special report" titled "Potential Catalyst for Deflationary Bear Market---Real Estate" which can be viewed by clicking on any special report and clicking on "previous" for older reports.

Existing home sales were up 2.9% in April, but have been at the same historically low level for the past six months.   An estimated 45% of sales are distressed properties while inventories are continuing to rise.   New home sales for April were up a minuscule 0.3% from a downwardly revised March number, and down 34% from a year earlier.   The sales level is near the lowest in over 40 years.   Furthermoreinventories of existing homes are likely to jump as a result of the endof moratoriums granted by financial institutions.   For the past few months most institutions with delinquent mortgages did not foreclose.   That period is now over and loads of additional houses will be on the market.

Despite the flattening of sales the housing market is still in a lot of trouble. Although home prices have plunged they are still too high relative to median family income and must come down significantly more before any decent recovery takes place. In addition the number of mortgages in default or foreclosure has continued to rise and we have begun a new wave of foreclosures.

Just as we measure stock market value by using a price-to-earnings ratio, we can measure home values by using the ratio of existing home prices to median family income. During the 34 years from 1966 to 2000 the average ratio of home prices (using the Case/Shiller data) to median family income was 2.75, with a high of 3.12 during the housing boom of the late 80s and a low of 2.28 in the 1970 slump. However, in the massive housing boom of 2002 to 2006, spurred by extreme easing by the Fed and issuance of mortgages to anyone who applied, the ratio broke all historical barriers and soared to 5.20. As we pointed out in these comments so many times, that ratio of price-to-income was clearly unsustainable and subject to collapse-and that's exactly what happened.

Since the housing price peak in February 2006 prices have plunged 31.4% according to Case/Shiller. The problem is that even at this level the price-to-income ratio is at 3.24, an amount that's higher than the late 1980s peak and 17.8% above the past average. This means that home prices would have to decline another 15% from here to equal the past average-and even more if prices undercut the average as is usually the case. Simply put, housing prices are still out of line with family income.

It seems like deja vu all over again as Barron's just had a cover story titled "BUY NOW" about luxury real estate. In the weekly comment dated 7/18/2008 "It's All About Housing" we attempted to explain our position which was, as you would expect, contrary to the article puts us in the same position today.

In addition to housing prices being too high relative to income, a recent New York Times article points out that a new wave of foreclosures is now underway. The big rise in unemployment this year has caused many prime mortgage holders with previously solid credit ratings to default on their mortgage payments. The surge has apparently led to a so-called third wave of foreclosures, that of prime borrowers. The first wave consisted of speculators selling their properties when prices started to fall while the second wave was made up of subprime borrowers. In recent months the increase in defaults and foreclosures by prime borrowers has surpassed that of both speculators and subprime holders. With the unemployment rate now at 8.9% and likely to rise above 10% in the period ahead, this new round of foreclosures will probably accelerate, putting additional pressure on the financial system as well as the broader economy. Moreover let's not forget that the overall unemployment rate including marginal and part workers is at 15.8% and rising

In sum, although new and existing home sales appear to be bottoming at extremely low levels, it is far too early to call for a meaningful recovery and a jump in foreclosures and inventories are likely. In our view the recent rally in the stock market has already taken it out of the undervalued zone, and the potential of an imminent economic recovery has been vastly overestimated.

Published on  Fri, May 29 2009, 05:57 GMT