U.S. Housing Market: Patterns Show an Impending Tsunami

Imagine a column of water in the Pacific Ocean, 4,000 meters deep and seven kilometers wide. And it's heading toward you literally at the speed of a bullet.

A volume of seawater traveling at that speed is classified as a Tsunami - the biggest and most devastating of all ocean forces.

The seventh most devastating natural disaster is the 2004 tsunami in the Indian Ocean that killed 287,000 people.

Now imagine that the pattern of that tsunami's formation, its growth, and its ultimate destructiveness perfectly mirrors an industry in our country.

And the damaging effects of the industry to which I'm referring on the U.S. economy have yet to make landfall…

It is astounding how closely events of nature mirror events of business. It shouldn't be much of a surprise, really. Leaders in finance have used the physical world to help describe and predict the events of finance for decades. The most famous example of this in my mind is the Nobel Prize winning work of Fisher Black and Myron Scholes. They adapted a heat transfer equation from physics to explain and value options contracts.

And that's only one example…

MIT economics professor Xavier Gabaix, along with a team of physicists from Boston University discovered that the movements of the stock market follow a mathematical pattern similar to earthquakes.

These findings could allow traders to protect their investments by pinpointing periods when market volatility is likely to be significant.

"The frequency of crashes such as those in 1987 and 1929 follow patterns," says Gabaix. "Although that doesn't mean we'll be able to predict with certainty when movement will occur, or in which direction it will go, we can still predict - better than with other methods - whether it will be a big move or a small one. And that information can be useful."

The patterns that give us clues of huge equity market changes and devastating earthquakes are known as power laws. Power laws define mathematical relationships between the frequency of large and small events. Typically, the larger the event, the less frequently it happens. The importance of these power laws is in the way they describe nature as well as artificial constructs…

What I'm worried about, though, is something that will affect everyone in America, not just stock investors…

It will be the second wave downwards in the housing market that will catch everyone off guard and send the economy into a sharp, protracted consumer-led recession. And that second wave is about to hit.

The housing market peaked in summer of 2005 right along with the cover of Time magazine proclaiming "Home $weet Home - Why we are gaga over real estate". Since then home sales have fallen dramatically nearly everywhere and price drops in the bubble areas such as Florida, Massachusetts, Phoenix, Las Vegas have been as large as 25% or more taking into consideration incentives, interest rate kickbacks, and even "free" vacations and cars.

Building permits in November dropped 31% from the year earlier level. Note that seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation).

Furthermore it was a plunge in the annual rate of change on permits that preceded every recession that makes permits a strong leading signal. The only miss was 1987 where the annual rate of change exceeded negative 20% but there was no recession. There was also a recession in 2001 even though the threshold of negative 20% was not hit (but the number did at least get strongly negative). That likely explains why the recession of 2001 was not as severe as most. Indeed when housing is strong hiring is strong and people also tap into the equity on their houses and spend it.

In early December of 2006, in One on One with Robert Toll of Toll Brothers (NYSE: TOL). Toll proclaimed that things are "dancing a little bit above the bottom" and that "all the ingredients to have a very rapid recovery are in place and I suspect you will see a rapid recovery once the pent-up demand understands that if they don't buy now, they may miss an excellent opportunity to buy a home with a low mortgage rate."

Actions however speak louder than words as Robert Toll has personally been bailing on his shares at a tremendous rate. The key elements however, are land options and cancellations.

Nearly all of the homebuilders have had high cancellation rates and have also been taking big writeoffs on land. Here is a prime example: Lennar (NYSE: LEN) posted a quarterly loss after land writedowns:

"Market conditions continued to weaken during the fourth quarter and we have not yet seen tangible evidence of a market recovery,'' Chief Executive Officer Stuart Miller said in the statement. Lennar said it's taking a charge to write down land it doesn't intend to purchase. It's also writing off deposits and pre- acquisition costs for land it has under option.

Would Lennar or any of the homebuilders be dumping land if they really thought the bottom of the housing market was in?

It has now been over 18 months since housing peaked in the summer of 2005.

But the average decline in housing starts from peak to trough is about 46 months. By that standard this decline has a long ways to go yet.

Foreclosures are actually at a fairly low rate. It is the rate of change however that is alarming. Foreclosures increase 51 percent nationwide.

Foreclosures increased 94 percent last year to 157,417 homes in California, as homeowners struggle with fast-rising home payments and a slow-selling market, according to a Fair Oaks real estate investment advisory firm on Monday. California had the most foreclosures filed nationwide, while Nevada had the largest percentage increase at 175 percent last year compared to 2005, according to Foreclosures.com. Nationwide, almost 971,000 foreclosure filings were reported last year, 51 percent more than the 641,000 in 2005, according to the annual report.

There has been some excitement in the housing market as of late by a small bounce in homebuilder sentiment as well as a small bounce in new home sales. This is like looking for starfish on the beach during the trough that precedes the big wave of the tsunami.

For starters, new home sales do not take into consideration cancellations and cancellations have been soaring. The current methodology is to count "new sales" as soon as a contract is signed, but sales are not subtracted by cancellations. Thus not only are sales overstated but inventories are massively understated. Builders are now scrambling to finish projects and unload as much inventory as possible before the next wave hits.

That second wave will strike when massive layoffs occur as the current projects are being completed followed by a decline on a lagging basis of commercial real estate. Already we are seeing an impact in residential construction employment. But do we really need more Walmarts, Pizza Huts, strip malls, nail salons, grocery stores, Home Depots, Lowes, and restaurants that follow? I think not and historically commercial construction follows residential construction with a lag. That lag is anywhere from 8 to 16 months.

Commercial business hires people and lots of them. When that buildout ends, and we are at the beginning of the end now, there is going to be no source of jobs to replace those service sector jobs going forward.

Mike Shedlock
for The Daily Reckoning Australia

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