Lately at Dohmen Capital, we are seeing how the Real Estate market now is somewhat reminiscent of the environment leading up to the Great Financial Crisis of 2008. However, we must keep in mind that there was a roughly two year lead time between the first signals of excesses and the crash of 2008.
Between 2008- 2009, many investors were burned, with the estimated losses equaling over 20 trillion U.S dollars.
Due to the devastating losses, countless investors have been fearful of getting back into Real Estate. This created new opportunities for savvy investors but also heightened risk for uninformed investors who still hang on to the false belief that real estate prices only go up over the long-term.
A popular and underused leading indicator for the Real Estate market is the housing starts index, which measures the number of new homes that developers are building. This number tends to precede future sales volume and housing prices.
Developers follow Real Estate trends and try to only build when the market is becoming stronger. Because of the long lead times, they often build the most at a top. They are often the victims of the same bad emotions as other investors that become the most enthusiastic at market tops. If developers can get the financing, they will build.
As you can see in the chart below, developers are currently beginning to produce fewer homes. Many analysts think that the developers know something we don’t, and therefore are looking for another Real Estate recession. However, our work shows that just like corporate CEOs who make a big acquisitions right at market tops, the developers make the same mistakes. In other words, when they’re cautious, it is bullish for the housing market.
If our observations still hold, it would be a bullish argument that could lead to excellent investment gains for smart real estate investors, at least over the intermediate term.
While housing starts generally precede Real Estate prices, there are also often “transitory” slowdowns that occur just before a strong boom. This actually occurred in 2004 as we will later explore.
In the chart, the bears would point out how the weakness in the Housing Starts Index trend over the past year (red line) is similar to that seen before the 2008 plunge (blue line).
As chartists, we could interpret the above chart as potentially bullish. Note that the red line has so far held the support level. Unless that support is broken to the downside, there is a possibility that the red arrow to the upside will be the future trend of housing starts.
We will watch what the housing market does very carefully over the next several months, especially as the a tax reform law is finalized. We consider that legislation very important, not only for real estate, but all the markets.
Timing is essential. The key, of course, is to avoid large losses while still taking part in the best opportunities. At Dohmen Capital, we look at ALL sides of the story, watching these indicators very closely and thoroughly filter the data to arrive at the most accurate conclusion. We don’t follow the crowd.
The Federal Reserve and Wall Street “analysts” have been quick to tell us this slowdown in Housing Starts is due to the recent Hurricanes. But, as seen above, the new slowdown began to occur back in January 2017, well before hurricane season.
Back in 2004 before residential Real Estate encountered big gains, the Housing starts index slowed and actually took a small dive before quickly reverting higher and making consecutive new highs. This is the concept of a “transitory” slowdown that often occurs before the BIG late-cycle boom.
Remember, 2004 is when the Fed finally decided to consistently hike rates. They had to hike rates 17 times until late 2006 when markets finally began to slow and Real Estate values began to “top out”.
Between 2004-2006, home values skyrocketed 30% across the country. Had investors got scared in 2004, they would have missed out on this huge upside, especially considering the 4X leverage generally used in Real Estate.
The Fed just began hiking rates this year and is doing so at a slower rate. With economic growth on the rise and more pro-growth tax policy likely on the way, Real Estate could be in for a large resurgence. However, if the U.S. Congress and the Federal Reserve once again make monumental mistakes, all bets are off.
The fact is that inventories of houses for sale are very low. All that is needed now is for the American consumer to see higher income.
We believe this year’s slowdown is more due to the uncertainty of tax laws, which will certainly be critical to the health of the housing market in the future. On November 9th, we saw how important tax policy is to all stocks, not only to the homebuilders.
With the change in Washington leadership, optimism has reawakened. What is needed now is Congressional action to put the new agenda in effect. That is still a big question mark.
Despite the slowdown in Real Estate, home builder stocks appear to be on fire. As you can see below, the Homebuilder ETF (XHB), which holds some of the biggest developer and construction material names like Home Depot and Lennar Corporation, has had a strikingly impressive run-up the last few weeks. This is contrary to 2006-2007 when the homebuilder stocks gave ample warnings.
XHB is up an impressive over 20% year-to-date with half of those gains in the past two months. Many of these homebuilder companies were nearly destroyed during the financial crises and have been quite slow to recover. Since then, these corporations have greatly reduced leverage and are starting to see a wave of sales growth.
The chart below shows the XHB ETF compared to the general stock market, represented by the S&P 500 Index. As we saw, the market took a hard fall during the last recession but has since recovered and nearly quadrupled in value from deep recession levels.
Who was left behind in this big stock market rally since 2009? The Home Builders, which, despite large growth in earnings, have basically not moved from their recession lows. In fact, these businesses STILL appear to have greater room to the upside, even with one of the highest valued stock market indices in history.
Looking at the price of these stocks compared to the earnings they produce, we can see that this industry has the 3rd (out of 95) cheapest valuation of the market, and a 5 year expected earnings growth much better than the general market. Could home builders be the next hot sector, as the charts are indicating?
Real Estate prices along with demand for new homes have had little movement for most of the post-recession era. However, over the last few years, and particularly the past year, prices have begun to see the same large acceleration they had encountered during the 2002-2007 bull market.
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Founder Dohmen Capital Research, Inc.
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