Don’t Get Too Comfy: Strong Home Sales Might Foreshadow a Correction

Source: Thinkstock

Source: Thinkstock

Investors applauded the existing home sales data that came out on Monday morning, as it showed that existing home sales rose in May to 4.89 million homes. This represents a 4.9 percent year-over-year increase. This data meaningfully topped analyst expectations of 4.73 million and a 2.2 percent increase.

The data sent shares of homebuilders rising, and those shares outperformed the broader market for the day. However, investors shouldn’t necessarily interpret this news as bullish. This is because existing home sales do not signify that demand for housing is increasing. These are existing homes — meaning that while one party is gaining, another is losing. People sell their homes for all sorts of reasons and we can list several that would not give investors a bullish outlook.

  1. Somebody dies and the family sells his or her home.
  2. A home price speculator lost money on another venture and needs capital.
  3. The bread winner for a family just lost his or her job and the family needs to downsize.

Of course, we can come up with several positive explanations as well, but the point is made that existing home sales don’t necessarily paint a positive picture. If you want to see whether there is an actual increase in housing demand, you need to look at new home sales and at prices. After all, if demand for housing increases, which would be a bullish indicator for the housing market and for the economy more broadly, then this would require a supply increase.

If we look at new home sales in May we find that this statistic declined by 6.5 percent. Furthermore, March’s new home sales upswing of 13.2 percent was revised downward to +12.7 percent, and we need to keep in mind that housing is seasonal and so the May figure is more important than the March figure.

So on this front, we get a much more bearish outlook for the housing market and for the economy.

If we look at prices we get a mixed picture of the housing market. According to the S&P Case Schiller Index, quarter-over-quarter home prices are up slightly by 0.17 percent. While this shows growth it also shows incredibly rapid deceleration, as the year-over-year increase is over 10 percent. Investors also have to keep in mind that any strength in the housing market is due in part to lower interest rates; if interest rates are lower, then the same monthly payment can buy “more house.”

With investors generally anticipating higher interest rates going forward, and with May’s decline in new home sales, one has to consider that the housing market in the United States is vulnerable to a correction, and possibly even a bear market.

The implications of this could be devastating. After all, the American economy is highly dependent on the housing market, and if the housing market turns south so will several other industries from homebuilders to financials to select retailers (e.g. home improvement retailers.) Therefore, investors need to watch the housing market very carefully. They also need to watch interest rates, and mortgage rates in particular. If the former begins to fall and the latter begins to rise, then investments that are highly correlated to housing and to the overall strength of the American economy could be vulnerable.

Corrections in these markets can be particularly violent considering the relatively optimistic attitude that investors have in today’s stock market. Stocks are pricing in continued earnings growth and low interest rates. Should investor perception change the S&P 500 could quickly trade lower. Right now, it has a 22 price-to-earnings multiple, but because of growth the forward price-to-earnings multiple (that is, the price-to-earnings multiple on analyst estimates) is 17. If expectations begin to weaken not only will the forward price-to-earnings multiple rise, but investors will be less willing to pay such a premium for these earnings, and a bear market scenario similar to the one we saw from 2007-2009 isn’t out of the question.

Disclosure: None.

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