What The Real Estate Cycle May Tell Us About Stocks

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By Gary Gordon :

According to the National Association of Realtors, existing home sales have declined for three consecutive months. Similarly, the year-over-year data have been negative in every month except for February.

Existing home sales are hardly the only weak spot in real estate. Sales of new homes fell 5.3% in June. Meanwhile, the Mortgage Bankers Association reported that purchase applications dropped 5% and overall application volume decreased 2.5% (through the week ending July 13).

There's more. Housing permits shrank on a year-over-year basis (June). In a similar vein, housing starts tumbled 12.3% from the prior month (May).

In extremely influential real estate markets like Southern California, the data are more daunting. Sales in this part of the country are the slowest that they've been in four years. According to Core Logic, the number of new and existing homes sold in the region plummeted 11.8% on a year-over-year basis.

The pattern today may be emulating the previous credit cycle. Specifically, home sales began declining in earnest in 2006 alongside higher mortgage rates. Yet home prices were still hitting highs until the start of 2007. In 2018, home sales have been weakening alongside higher mortgage rates. Is it only a matter of time before real estate prices follow suit?

Take a second look at the chart above. Notice the dramatic drop in the 30-year fixed from approximately 8.5% in early 2000 down to 5.5% in early 2003. Then, due in large part to Federal Reserve policy, mortgages tended to remain in the sub-6% arena during the real estate melt-up (2003-2006). As mortgages climbed off of the 5.5% level up toward the 6.5% level and as the Fed stayed the course on maintaining its Federal Funds Rate more than 400 basis points above the previous cycle low, real estate price appreciation hit a wall (2007).

The next time around, the 30-year fixed dropped from roughly 6.5% in 2008 to 3.5% by the start of 2013. Much like the previous decade, 300 basis points increased home affordability payments for a period, and ultimately, sent home prices skyward (2013-2018).

Now, however, the 30-year fixed has moved off of those lows to 4.5%. With prices at record highs in most places in the country yet again, affordability would be lost if mortgage rates were to move meaningfully higher from here. (Bring back "neg am" and "no doc" and other exotic loan types?)

For instance, the "taper tantrum" in 2013 witnessed an average 30-year pop from 3.5% to 4.5% by year's end. That rapid-fire move coincided with the only meaningful spike in inventory outside of the one that is taking place right now.

"Okay," Gary. "You've got my attention. But what does this have to do with stocks?"

For one thing, when home sales crater, a number of economic sectors tend to struggle. Construction wanes. Lending slows. Even home improvement companies might take it on the chin.

Keep in mind, residential investment alongside housing services consumption represent "housing" in the U.S. And "housing" represents one-sixth of gross domestic product (( GDP )). If the slowdown takes root, economic growth will suffer.

Granted, few economists believe that recession is imminent. Yet if current fiscal stimulus (i.e., tax cuts) fails to sustain above-trend GDP at a time when the Federal Reserve is raising overnight lending rates and reducing its balance sheet, homebuilder stocks may not be the only ones sent to the dog house.

Here's an additional bit of information that drives the point home. According to Edward Leamer's work at the National Bureau of Economic Research, problems in residential investment contributed approximately one-fourth of the economic weakness in the year before eight recessions since World War II.

In other words, a small GDP component like residential investment (3-5%) accounted for a supersized (26%) portion of economic weakness in the year before a recession, making residential investment a powerful indicator. It follows that, if stock assets themselves fare poorly leading into economic downturns, it may make sense to monitor residential real estate trends.

It's true that economic growth at 4%-plus right now looks solid. Moreover, unemployment lows, record earnings per share on tax cut stimulus and $1 trillion in stock buybacks appear to be wonderful tailwinds.

I guess the big question, then, why is the S&P 500 still struggling to take out the January highs? Maybe it is nothing more than a six-month "breather." Or perhaps higher borrowing costs are affecting more than mortgages alone.

Even then, the Fed is going to keep raising its Fed Funds Rate and reducing its balance sheet to give themselves more ammunition to fight a recession down the road. The financial markets may not believe Chairman Powell's resolve. However, Powell is keenly aware of what the Fed needed in firepower to fight previous recessions.

At present, the range for the Fed Funds Rate is just 1.75-2.0%. If the Fed needed to lower the target by more than 500 basis points in the last three recessions, not to mention employ emergency quantitative easing ((QE)) to battle the Great Recession, what makes people believe that Powell will stop hiking anytime soon? For that matter, the Fed will invert the yield curve in the very near future and take their chances with whatever yield curve inversion does to stock assets.

Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships.

See also Quaker Chemical's ( KWR ) CEO Michael Barry on Q2 2018 Results - Earnings Call Transcript on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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