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A Bubble or a Value?

In a recent column, I talked about Toll Brothers' (NYSE: TOL  ) chairman, Robert Toll, and how he and other insiders sold company stock aggressively from late 2004 until June 2005. They conducted this selling campaign while telling investors all along that their business was sound and not vulnerable to any downturn in the housing market. They derided any claims about a housing bubble, despite a rising chorus of concern among economists and analysts. Even former Fed Chairman Alan Greenspan chimed in with a cautionary note that housing prices looked "frothy" in some areas. Bob Toll openly ridiculed the forecasts.

Fast-forward to today: Toll Brothers' stock is down about 50%, and investors have lost a ton of money. Now, as the housing market deflates -- something Toll said wouldn't happen -- Bob Toll is among the principal finger-pointers. In an extraordinary display of gall, Toll says that the market is struggling because of "speculators and the Iraq War." Never once does he entertain the idea that builders like him may have misread conditions and gone on a construction binge that ultimately led to the current inventory glut.

Or is there a glut? Toll's comments, both now and in the past, have made me want to delve further into the story.

A historical perspective
Sentiment is always very important to a contrarian, but I like to have some hard economic evidence as well. That's why I'm looking at some critical housing data to see whether the information supports the thesis that the homebuilders have indeed hit bottom.

I'll begin with building activity, because overbuilding was probably the key factor that led to the housing market's peak and subsequent downturn. Using data on housing starts going back to 1959, I found that the 2.265-million unit annualized pace that the market hit in January of this year was its highest in 33 years. In addition, the pace of the eight consecutive months ending in February, during which new starts exceeded two million, is matched only by the period from 1971 to 1973. That was an extraordinary period -- the feverish construction pace back then continued for 28 consecutive months!

That early-1970s boom in housing construction led to a clear oversupply of homes, as the inventory-to-sales ratio shows: For every buyer of a new home, 3.5 new homes were being constructed. It took about a year and a half for that inventory glut to be eliminated. When the inventory-to-sales ratio fell below 2:1, construction activity started again.

The mid-to-late 1980s was another period in which the inventory-to-sales ratio rose to high levels. A market downturn again ensued, triggered, perhaps, by the 1987 stock market crash.

In the early '90s, builders had become extremely cautious. And who could blame them? The country had just gone through Gulf War I, and the economy was slowed by the 1990-1991 recession. In January 1992, the inventory-to-sales ratio had hit an all-time low of 1.7:1. A year later, another building upturn was under way; that one peaked in early 1995.

Beyond all the hoopla
Now comes the interesting part. Over the past 10 years, the inventory-to-sales ratio has been trending lower; it hasn't topped its 10-year average during the entire period. The reason seems to be that people have been buying homes like mad, while builders have maintained enough discipline to keep inventories in check. Consider this: In March 2005, even after all of the speculative frenzy surrounding the housing market, the inventory-to-sales ratio dropped to a new all-time low of 1.4:1. Since then, it has climbed back to 1.7:1; but that rate still remains below the 10-year average.

Moreover, recent construction data shows that housing starts are declining. In July, single-family starts experienced the biggest year-over-year decline in 11 years. Year to date, 400,000 fewer units have been built than last year. Even more telling, perhaps, is the year-over-year decline in building permits -- the biggest in 15 years.

We've heard a lot of talk about the supply of new homes on the market, but that figure needs some perspective, too. According to the Census Bureau, which compiles this data, the number of new homes on the market at the end of July was a record 568,000. That is the equivalent of 6.5 months of supply, which is elevated but far below the 11.6 months of supply back in April 1980, or the 9.4 months in January 1991. The oversupply of new homes, therefore, seems moderate.

With supply by no means excessive, and with builders already reacting aggressively to market softness, the key to what happens next lies in buyer behavior. Only a significant downturn in homebuying can ensure the kind of excess inventory that has, in the past, produced lasting housing recessions. So let's take a look at housing affordability and the financial position of prospective homebuyers.

While personal income is now rising at the fastest pace in six years, real income, adjusted for inflation, is rising much more slowly. The good news, however, is that real income in 2006 is growing more than twice as quickly as it did in 2005. Moreover, if the recent fall in petroleum prices continues, then real incomes are about to get a big boost. That should be great news for homebuyers and for the housing market. I say should because I'm assuming that we won't see a big upturn in unemployment. If that happens, my calculus goes out the window.

The second factor is overall affordability. With real income now rising, we at least know that one factor will help to boost affordability. However, when you add falling home prices and falling interest rates, you produce a very powerful cocktail. According to the Census Bureau, the nationwide median price of a new home fell about 3% in the second quarter when compared with Q1, and prices are still below where they were in Q4 2005. Although third-quarter figures are not currently available, recent anecdotal information on the real estate market suggests that prices have fallen even more.

What bubble?
In addition to the price decline, we have seen a pullback in interest rates. In July, the rate on a 30-year conventional mortgage hit a high of 6.93%, up from 5.53% one year earlier. However, rates have declined recently, and the 30-year mortgage is now around 6.44% percent -- about half a percentage point lower than it was two months ago. It may not sound like a lot, but it adds up to about $80 per month in savings in principal and interest on a $240,000 mortgage. That translates into about $1,000 per year in additional spending (or saving) power.

Adding it all up, I've come to the conclusion that barring any major upturn in unemployment, the housing market still looks pretty sound, notwithstanding this period of softness. More importantly, the homebuilding companies look like incredible bargains -- they remain deeply, deeply undervalued. Mr. Market has once again come knocking on your door with wonderful discounts. You might not want to let this opportunity pass. I'd take a closer look at these downtrodden homebuilders.

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Fool contributor Mike Norman is the founder and publisher of theEconomic Contrarian Updateand is a Fox News business contributor. He is also a radio show host at BizRadio Network. He does not own shares in any of the companies mentioned in the article. The Motley Fool has a disclosure policy.


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7/28/2014 10:16 AM
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