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The Housing Market Is Complicated

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Yesterday, I was talking about how companies would be cutting back production if demand started to shrink. And today, I want to talk about the housing market where we are already seeing it happen.

According to the latest available data, new home sales dropped 16.6% in April, mainly driven by the higher cost of construction (that is being passed on to consumers). Existing home sales are also coming down (-2.4% in April) as prices remain elevated and mortgage rates continue to climb.

One would have expected less caution from homebuilders given the significant demographic-driven demand out there and people only staying away from the market because of the high prices. Nor is there any possibility of inventories piling up if prices are lowered, given the strength of underlying demand.

But builders don’t seem to be in the mood to take risk. One reason could be the persistent cost escalation, both in terms of raw material and labor. Whether they will be willing to build inventory once the supply chain normalizes and the labor market cools (somewhat at least) is anybody’s guess. Since oil and gasoline prices aren’t expected to soften much, it doesn’t look likely to happen any time soon.

Builders could also be factoring in much weaker demand over the next couple of years as a result of the rate hikes. Maintaining lower inventories would allow them to collect better prices. The S&P CoreLogic Case-Shiller 20-City Composite Home Price Index certainly seems to be rising to the occasion (pun intended). Between Jan 2021 and March 2022, there has not been so much as a pause, with price increases actually accelerating in the first three months of this year.

Now let’s take a look at a couple of charts. Housing market data comes from a number of places, including the Census Bureau, the HUD and the National Association of Realtors to name a few, and they are released at different times and for different periods, all of which makes the data a little difficult to correlate. But the trend lines still tell the story:

Zacks Investment Research
Image Source: Zacks Investment Research

As evident from the above, new home sales (green line) flatlined between Dec 2021 and Feb 2022 before dipping lower.

The inventory position (red line) also flattened in these three months and increased ever so slightly since.

Housing starts (blue line) that had been buoyant since October, dropped sharply in May. As starts were holding relatively steady up to April, inventory increased slightly. But with starts dropping off so sharply in May, inventory increases could be checked even if demand falls further.

And finally, existing home sales (orange line), which make up a significantly higher share of home sales, also continue to trend lower.

The effect of increasing mortgage rates on demand is seen in the chart below:

Zacks Investment Research
Image Source: Zacks Investment Research

As is clear from the above, the 30-year mortgage rate (green line) has been rising quite consistently from Feb 2022. Mortgage applications (orange line) have been mostly in negative territory. Last week’s spike was likely in order to get in before the Fed’s rate hike announcement this week.

Conclusion

This creates a peculiar problem. While rate hikes are designed to cut consumption, the end goal is to have inventories build up so prices can come down. But home builders are reacting quickly to the slight inventory increase, which is keeping prices high. Prices in the housing market really need to come down because they are the most significant factor in fighting inflation in the core basket (minus food and energy).

If this continues, and production continues to shrink, it could send us into a recession.

Better Buy

Because of the above situation, it’s probably a good idea to avoid homebuilders right now. Safer bets are diversified chemicals suppliers Brenttag SE (BNTGY - Free Report) and Kronos Worldwide, Inc. (KRO - Free Report) , steel producers Nucor Corp. (NUE - Free Report) and Ryerson Holding Corp. (RYI - Free Report) , as well as Daqo New Energy Corp (DQ - Free Report) .

Sporting Zacks Ranks of #1 (Strong Buy) or #2 (Buy) and value-growth-momentum (VGM) Scores of A or B, these stocks belong to happening industries. So they have better chances of appreciation. Additionally, analysts are also positive about them, as evidenced by their recent estimate revisions.