Physicians' Guide to Wealth

A guide for anyone pursuing financial independence

Bad News is Good

Jul 20, 2022

Yesterday, the National Association of Home Builders index reported its second largest one-month decline since the massive decline experienced in March 2020. The Home builder index dropped to 55 and has been steadily declining since its peak in December 2020. July was the 7th consecutive negative month-over-month (MoM) decline.
The National Association of Home Builders produces a housing market index based on a survey in which respondents from this organization are asked to rate the general economy and housing market conditions. The housing market index is a weighted average of separate indexes that include present sales of new homes, sales of new homes expected in the next six months, and traffic of prospective buyers in new homes. Although a reading above 50 remains positive, the steady sentiment decline among home builders would indicate the sizzling hot residential builder market has peaked for the near term.  
NAHB Chairman Jerry Konter stated in the report:
 “Production bottlenecks, rising home-building costs, and high inflation are causing many builders to halt construction because the cost of land, construction, and financing exceeds the market value of the home”. In another sign of a softening market, 13% of builders in the HMI survey reported reducing home prices in the past month to bolster sales and/or limit cancellations.”
Based on a short-term perspective of the housing market, one would assume that the dire days of the 2008 housing crisis may be looming. However, not only is the housing market, builders, and home buyers in significantly better financial condition than in the past, the index remains well above low points in the index going back to 1985 when the NAHB started publishing this report.
However, this bad news is really good news. Jerome Powell, Federal Reserve Chairman, and his committee have been on a mission since last year to slow the US economy down and reduce inflation. Their primary weapon has been raising the Federal Reserve Discount Rate, which starts a domino effect of rising interest rates in all other markets and specifically mortgage and lending. The first big domino to fall was home refinancing that stopped in its tracks in the first quarter, with new refinance applications down for several weeks by almost 90% year over year. Next was new and existing home sales slowed as mortgage rates increased by 100%, wiping out the eligibility of millions of home buyers due to higher monthly mortgage payments. Buyers only have so much discretionary money for mortgage payments, and until home prices decline, they are unable to qualify for the purchase. This is also good news for multi-family developers and property owners as the rental market has boomed with millions of formerly qualified home buyers now excellent tenant prospects looking to rent and wait until they can afford to buy.
National home builders (Lennar, Pulte, DR Horton, etc.) are billion-dollar machines that can’t stop production overnight. Slowing down this industry would take time, and surprisingly it only took less than a year. Housing developments from small (50 homes) to 1,000’s homes take years to get through the extensive process before they can start excavation, including land entitlements, plan design, engineering, permits, utility access, environmental approvals, etc. Once the construction company starts a development, it is difficult and expensive to stop lending and carry costs that continue until the builder can complete the project and refinance or sell the development. Many builders and developments in the 2005-2010 housing crash went bankrupt due to the inability to complete the project.  
This last domino of slowing the multi-trillion dollar home builder industry is good news for Jerome Powell and his committee. Residential housing is the largest asset of most households and the number one source of consumer spending (refer to Housing Boom or Bust). Therefore, smartly the committee focused its efforts on slowing inflation by slowing the housing market that impacts the largest demographic segment of this country, which includes lenders, real estate agents, builders, architects, engineers, investors, TV home improvement shows, and almost everyone accepts landscapers and pool care providers.  
The challenge for the Federal Reserve is to slow the real estate industry without driving it into a crisis. The key to avoiding this disaster of another cycle of massive foreclosures and bankruptcies is the differences in the industry vs. in 2005. According to Policy Advise, since 2017, homeowners have been paying down their mortgages faster, with nearly 40% of homeowners debt free. Secondly, the refinance boom of the past several years had allowed homeowners to secure sub-4 % fixed rate mortgages that lock in their monthly payments vs. the devasting variable loan rate mortgages that drove millions into foreclosure when the initial teaser rate period ended.

What Does This Mean to Me?

Institutional investors are currently evaluating the prospects of the Federal Reserve slowing its rate hike policy by the end of this year. The Consumer Price Index has reported still high rates of rising costs, but this index is a trailing indicator. The decline in activity of the multi-trillion-dollar real estate industry will have an impact on rising costs and upcoming CPI reports. The stock market is typically a gauge of the prospects of the economy 6 to 12 months in advance. Therefore, the potential for a favorable second half of 2022 and the beginning of a multi-year uptrend would be indicated should the S&P 500 begin to settle into a base and resume an uptrend this year. As mentioned in the previous Brief, “Deciphering the CPI”, the S&P 500 completed its first trailing monthly positive return for the first time this year.  
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