The decline in the housing sector in 2006 – 2007 was incredibly difficult for consumers and the U.S. economy. There is no doubt that the disruption in the mortgage market (and its derivatives) was a primary cause of the credit crisis and market crash in 2008.
Unfortunately, many of the risks in the housing sector are just as serious now as they were prior to the crash, despite the decline in unemployment and lower interest rates.
Credit derivatives based on mortgages are at roughly the same levels as they were in 2007, and controls are still fairly lax. The only significant change over the last few years has been stricter requirements for real estate loans to consumers.
However, that slack (and much more) has been absorbed at the institutional level. Stability in the housing sector is still critical, which is why we watch it so closely.
Some of the most important bellwethers within the housing and real estate market are the publicly traded homebuilders like PulteGroup, Inc. (NYSE:PHM), D.R. Horton, Inc. (NYSE:DHI) and Lennar Corporation (NYSE:LEN), even though they only represent a small fraction of total building and construction in the U.S.
If these companies are under pressure, then we can assume that the entire housing sector is feeling a squeeze.
The fundamentals within the real estate group have been improving, but there are at least three primary issues that have emerged or worsened over the last few months.
Housing Sector – Low Growth
Somewhat counter-intuitively, the major homebuilders that survived the decline seven years ago have not levered back up. There are several reasons for this, including a relatively high cost of capital and a shift to more conservative management strategies.
However, it means that these companies have moved from a “growth at any cost” to a “stability at any cost” strategy. There is nothing necessarily wrong with that approach, but it has allowed a myriad of smaller competitors to overcome moats and move into their territories and, as a result, margins are shrinking.
Housing Sector – Rising Interest Rates & Low Oil Prices
The second issue is that the moderate growth these real estate firms have been experiencing is likely to be curtailed because of a slowdown in the oil sector and rising interest rates. The Federal Reserve announced yesterday that it will remain “patient” before raising rates but did not reset expectations that an increase would be coming in late 2015.
If all else remains equal, higher interest rates means fewer mortgages and homes.
Contraction in the oil sector will put pressure on the largest housing markets in the U.S., including California and Texas. Compressed margins and reduced demand from a combination of higher interest rates and falling industrial production is likely to put a lid on the potential gains within the major homebuilders.
Keep in mind that a primary cause of the savings and loan crisis of the 1980s was a collapse in oil prices that put pressure on the housing sector.
Housing Sector – Momentum is Fading
Finally, from a technical perspective, the housing sector has been losing momentum. Mixed results from D.R. Horton and KB Home (NYSE:KBH) have perplexed investors, while durable goods orders dipped for the fourth month in a row. The SPDR sector exchange-traded fund that follows the homebuilder/durable goods sector is the SPDR S&P Homebuilders (ETF) (NYSEARCA:XHB), which is pictured below.
As you can see, the XHB ETF has formed a large bearish divergence with a volume blowout on Jan. 13, following the KBH report. We would expect the highs earlier this month to act as a very firm level of resistance regardless of the actions of the Fed.
There are still some homebuilder reports waiting to be released in the short term. Despite the positive surprise in new home sales released by the Census Bureau on Tuesday, building permits and existing home sales were down.
The pending home sales report later this week should also give us a better idea of what lies ahead. A decline in the housing sector isn’t necessarily an economy-killer, but it would certainly point towards some rocky expectations for 2015, which is why it’s such an important indicator.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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