Sunday, November 4, 2007 0 comments ++[ CLICK TO COMMENT ]++

A Revelation for Me: Housing Inventory May Not Matter As Much

I read a very good analyst report from HSBC (When will the homebuilding bust end? by Ian Morris and Ryan Wang, HSBC (Nov 2 2007)) where they try to shed some light on when we might hit the bottom of housing. Every single Wall Street analyst has been guessing and been wrong for over an year (recall the somewhat infamous calls in late 2006 for the bottom, which turned out to be completely wrong!)

The analysts identify 4 prior housing corrections where residential construction has declined for 4 or more quarters. The prior 4 construction declines were in 1966, 1973, 1981, and 1990. They look at a bunch of different metrics, ranging from unemployment rate, to GDP contribution from housing, to % of gross domestic demand, among others. Using these metrics, they compared the current correction to the prior ones and tried to determine when we might see the bottom.

Perhaps the most bearish way of looking at it is if you look at housing share as a percent of GDP. Using this metric, HSBC estimates a bottom in Q3 2008 if nominal residential construction declines 20%; if annual nominal construction decline is 15%, they estimate the bottom is in Q4 2008; and if annual nominal construction decline is 10% then they peg the bottom in Q2 2009.

Anyway, one of the points that they present in the report radically changes my view of housing. All this time, when I was evaluating homebuilders and other housing-related stocks, I paid a lot of attention to housing inventory. The inventory number is very high and looks scary for a homebuilder. However, they point out in the report that new home sales and building permits bottom out at the same time:

How can things bottom out
when we know that new home supply is still very
high? The months’ supply of new homes hit 9.0 in
August, a cyclical high.

Although it is popular to use months’ supply as a
barometer for future construction activity, it does
not do well in practice as a forecasting tool.
home sales and building permits tend to bottom
out at pretty much the same time that months’
supply of new homes peak (see chart 8...).

(source: HSBC, modified by Sivaram Velauthapillai of Can Turtles Fly)

Note that the blue additions in the chart above are mine. You can clearly see that if one wanted to capitalize on a recovery, one can't wait for inventory to get to comfortable levels. Inventory, as measured by months supply of homes, starts to decline but never really hits a low level until well into a boom. I guess this is obvious if you realized that housing is cyclical like commodities but it never occurred to me. Just like how cyclicals have low P/Es during a peak and not at a trough, if housing inventory is very low then we are probably near the end of the cycle.

What I learned from this is that I should watch something like new home starts or permits instead of waiting for a comfortable level of housing inventory. By the time inventory hits a comfortable level, one probably already missed the big portion of a bull market.

The homebuilders may not be in as dire straits as it seems if we are close to the absolute bottom. None of this means that you will hit the profit levels of a few years ago, when things were booming; however, it does mean that homebuilders will stop bleeding red and should see a decline in write-offs. This somewhat less-bearish picture is probably what makes Countrywide Financial (CFC) come out and say they may make money next quarter.

Having said all that, note that one of the cases put forth by the housing super-bears is that what happened in USA is unprecedented in terms of housing. We have never seen such a huge housing boom throughout almost the whole of America (incidentally there were also housing booms in other parts of the world). The risk with wading into housing any time soon (soon means up to middle of next year in my books) is that we may be seeing something new this time. If it's anything like Japan, it's going to be a disaster for a long time. This is one reason I'm partial to the Pulte bonds instead of equity.

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