Cracks in the Ceiling
Of the Housing Boom

By MARK GONGLOFF and DAVID GAFFEN and ED LEAMER and SCOTT PATTERSON
Staff Reporters of The Wall Street Journal

From The Wall Street Journal Online

This week's Trading Shots column welcomes UCLA professor Ed Leamer. Dr. Leamer is director of the UCLA Anderson Forecast, which provides quarterly economic projections for the nation and the state of California.

Mark Gongloff: If you're trying to find a slow leak in a tire, you can submerge it in water and look for tiny bubbles of escaping air. That may be the best way to look for signs of a deflating housing market, too.

After all, just going by the big indicators, the housing market still looks plump. Sales of pre-owned homes, the bulk of the housing, hit record pace in June, with prices posting their biggest gain since the Carter administration. But there are tiny bubbles escaping, which shouldn't make you feel happy or fine (apologies to Don Ho) about the boom.

The most important indicator is probably the growing length of time "For Sale" signs are sitting on lawns across the country. The Wall Street Journal and New York Times recently published big-picture reports on that, but smaller papers, from New Hampshire to South Carolina to Palm Springs, Calif., had already presented the tiles for that mosaic. "This happens in every cycle," says Wellesley College economics professor Karl Case, who has published several studies of the housing market with Yale economist Robert Shiller. "The first sign [of a slowdown] is always time on the market and inventory."

Yet there are other, even tinier bubbles rising to the surface. New-home construction has plateaued in the past year, though at a high level. Mortgage applications have fallen in four of the past six weeks. The inventory of foreclosure properties rose nearly 5% in July, according to Foreclosure.com, and is up 10% in the past year. Sales growth at home-and-garden centers and furniture stores has slowed sharply from a peak in early 2004, according to Commerce Department data. As of the second quarter, Home Depot and Lowe's were still making money hand-over-fist, but their share prices have flattened in the past month, with investors worried that higher interest rates will hurt business. Furniture sales have fallen in three of the past five months.

Another leading indicator could be a slowdown in the pace of new-home sales, says Richard DeKaser, chief economist with National City in Cleveland. Unlike homeowners, who tend to resist cutting prices, homebuilders are more willing to slash prices on brand-new homes to get rid of them, if they have to. "If a price adjustment is required, we will see it there first," he says. "My read there is that we may be seeing price-softening already in the process of playing out." The National Association of Home Builders' index of new, single-family home sales fell for the second straight month in August, matching its lowest level of the past year.

If these are simply signs of a healthy market adjustment, that's good news. But more of a slowdown could also hurt the broader economy, which, together with higher interest rates, could put even more pressure on this overinflated tire.

David Gaffen: At least three television shows today -- one on the A&E channel, no less -- extol the virtues of buying, renovating and selling houses for a quick profit. TV shows about "flipping" is the real-estate equivalent of what JFK's dad, Joseph Kennedy Sr., said about the 1929 stock scene: It's time to sell when the shoeshine boy starts talking about the market.

The Learning Channel has "Property Ladder," hosted by "veteran real-estate investor and flipper Kirsten Kemp"; its sister network, Discovery Home, has "Flip That House." That competes with the just-as-imaginatively named "Flip This House" on A&E (we could spend all day arguing whether flipping is an art, entertainment or both). All three premiered within the last two months. And why not? Housing has been a terrific investment -- Freddie Mac says the annualized five-year rate of home price appreciation was 8.38% as of first quarter, the best it has been nationwide since 1982. Still, the idea of several TV shows explaining how Joe Sixpack can make easy money in real estate through what amounts to speculation should trip an alarm or two.

There is an old adage that magazines and books are great contrarian indicators. Business Week's famous "The Death of Equities" cover in 1979 and James K. Glassman's "Dow 36,000" tome from 1999 are storied examples. Life Magazine in February 1970 published a cover foretelling how America beat inflation -- just before inflation boiled over. There is an interesting twist, though: While magazines and other publications can be churned out quickly to ride a trendy wave, studio productions often takes months of work, and by the time they hit screens big and small, there is a real danger that the peak is well in the past.

Oliver Stone's "Wall Street" was poignant, but it premiered nearly two months after the 1987 crash. Meanwhile, two drop-dead awful TV shows, "Bull" and "The $treet," premiered in 2000 just in time to follow the market into the toilet. "Television is so removed," says Barry Ritholtz of Maxim Group. "By the time an idea has totally infiltrated the public ... it's usually very late in the stages of that trend."

Sure, home renovation has always been a part of TV since Bob Vila's "This Old House," and TV shows like "Extreme Makeover: Home Edition" have somewhat noble agendas. But those shows are about bettering quality of life; flipping is about making quick bucks in a difficult game to play. Once the cameras start rolling, the losers are likely to turn up fairly quickly.

Ed Leamer: The history of residential investment offers a Hobson's choice: either a housing-induced recession or a war the magnitude of Vietnam or Korea.

The figure here depicts real residential investment per worker since 1948, with the official recessions shaded. (Residential investment includes new homes and brokerage fees, but doesn't include housing appreciation.)

This spending on homes varies from recession lows of about $2,500 per worker to expansion peaks near $4,000. During the recession of 2001, we were at that high $4,000 level, but we ploughed right through the recession without noticing it, and in the second quarter of 2005 we achieved the all-time high -- $5,233 per worker. Cut that back by $1,000 to get it into "normal high" range and you lose $1,000 times 140 million workers. That's $140 billion in lower spending. That's enough to cause a recession, if it occurs rapidly.

Can we get out of this mess? There have been two "false positives" -- problems in the housing sector that didn't precede recessions. One was in 1966-67. Spending on the Vietnam War saved the economy that time. The other was 1950-51. Then it was the Korean War. Pretty dismal news, for sure.

For perspective, Defense Department spending on Iraq and Afghanistan was 4.8% of gross domestic product in 2004 according to the Bureau of Economic Analysis. During the Vietnam and Korean wars it was as high as 10.2% and 15% of GDP, respectively.

Scott Patterson: The stock market is often a step ahead of the economy. Markets usually plunge well before recessions strike, for instance, as seasoned investors catch an early whiff of the slowdown. Could shares of home builders be telling us something about the housing market?

DR Horton is off 17% from its 52-week high. Also off highs are Hovnanian Enterprises (down 19%), Pulte Homes (off 12%) and Toll Brothers, which has coughed up 18%. The Dow Jones Home Construction Index has declined 10% so far in August. July saw the most insider selling of home-builder stocks on record, 5.1 million shares, according to Thomson Financial.

There are some stock-specific reasons for these declines, but general worries that rising interest rates could reverse the housing boom are taking a toll across the board. Home builders got whacked particularly hard recently after the Labor Department reported strong jobs growth in July, which caused investors to bail out of bonds, sending yields higher. Bonds tend to decline on signs of economic growth, such as rising employment. Since mortgage rates are tied to Treasury yields, home-builder stocks are especially sensitive to the bond market.

Hovnanian took a hit after it said the number and dollar value of net contracts in the West declined in its third quarter due to development delays. Net contracts also declined in the Northeast. Toll Brothers sports a bruise from an Aug. 4 downgrade by Wachovia Capital Markets analyst Carl Reichardt. One reason cited for the downgrade: His firm's July neighborhood-watch survey showed signs of a sharp slowdown in Washington, D.C., where Toll Brothers does a lot of business. Rising prices for homes were making it difficult to find buyers, sales managers said.

Sales managers are also hinting at trouble in northern California, said Mr. Reichardt, where prices have started to hurt traffic and sales. What's more, PMI Mortgage Insurance's U.S. Market Risk Index, which estimates the probability of house-price declines based on affordability, recently showed that the risk of falling prices increased in 36 of the nation's 50 largest housing markets. Four California markets -- San Diego, San Jose, Santa Ana and Oakland -- had a more-than 50% likelihood of price declines, according to the index.