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In 2006 when housing prices were at their peak I wrote:

“The credit driven housing bubble remains the greatest risk to the equity markets at this time.”

Since the government stimulus programs kicked in around late 2008 I turned mildly bullish on U.S. housing.  With the understanding that government backstops would likely bolster the market I said:

“Housing [will remain] in a steep decline, though the rate of decline slows substantially by the middle of 2009.  The market does not rebound, but false hope of a sharp turnaround appears possible by the end of 2009.”

Earlier this year I wrote:

“While we believe housing markets could show signs of life this Spring we continue to think the recovery in housing is almost entirely stimulus based and the long-term bear market in housing is still very much alive.  The laws of supply and demand have been temporarily lifted as the government attempts to price-fix a broken market.  In the long-run, however, the market is likely to return to its negative trends as the second round of mortgage resets and inventory overhang impose their will on a still very fragile U.S. consumer.  All of this adds up to a potentially bullish H1 in housing followed by a potentially treacherous 2011.”

In our 2010 outlook I said the government’s stimulus programs would continue to bolster asset prices (including equities).   But with the housing tax credit coming to a close in the next few days it’s finally time to take a look at these markets for what they really are and not what the government has been making them out to be.  In other words, the laws of supply and demand will come back to some semblance of reality.

As I’ve maintained, the price stability in housing has been primarily government induced.  The “false dawn” we have been seeing has been primarily due to in incentives bolstered market and government spending that papered over the weakness in the private sector.   Housing is notoriously seasonal and in my opinion the government couldn’t be stepping aside at a much worse time.

Although we’ve seen some certain signs of stability in recent months we’re also beginning to see some signals that could be forecasting the next leg down in the housing market.  The following chart shows the housing loan performance index compared to the Case Shiller data.  Loan performance has already started to turn south and Case Shiller data is only just beginning to show continued signs of weakness:

In addition, we’ve seen an incredible surge in lumber prices over the last year as builders have ramped up demand and supply has remained tight.  The index has risen almost 50% in 2010 alone.  Demand for housing starts has remained quite strong and the homebuilders have been eager to continue adding supply to the market as they attempt to remain afloat.  The surge in lumber prices is consistent with the low levels of supply in the market.  The builders are making the problems worse.  While this has been viewed as a near-term positive it is likely contributing to the long-term structural problems in housing as supply remains far too high.

As the following chart shows, the historical supply of housing remains quite high.  Housing supply has historically troughed in the 4-5 month range while we remain at 8 months of supply.  Making matters worse is the growing inventory in the “shadow” market.  We continue to see record foreclosure activity and Credit Suisse estimates that total foreclosures could reach 6MM in 2010.   Without a continued surge in demand it’s likely that supply will remain a heavy drag on the market.  As we’ve previously explained, the likelihood of a robust private sector recovery before 2012 is unlikely so demand for housing is likely to remain fairly weak in the coming years.

Adding fuel to the potential fire is the option ARM situation.  We have been in a relative lull in terms of mortgage resets.  That is set to change in the coming months as resets pick-up again:

Taking a much longer historical look you can see from the Case Shiller data that housing has performed just over the rate of inflation over the last 120 years.   The latest Case Shiller data shows a continuing divergence between the historical average housing prices and current prices.  The math here is not terribly complex.  Prices must fall (or remain flat for MANY years) in order to come back in-line with historical trends.  This is not only due to the high level of supply, but also a result of what is likely to be continuing weak labor markets, low wage growth and a generally weak private sector.

So how will it all play out?  I have broken the likely scenarios down into four different outcomes based on the likely 1-5 year price action: A, B, C and D:

A.  This is the bubble reemergence scenario. House prices climb 10%-25% in the coming years.  In my opinion, this is only marginally worse than a full-blown depression outcome (a full 50% decline from peak to trough).  This outcome means Bernanke, like Greenspan, is too accommodative, fiscal policy leads to price inflation, the housing bubble is fully re-inflated, the boom ensues and the inevitable bust follows.  As Richard Koo says, this second bubble bursting has the potential to be far worse than the first.  Nonetheless, I believe the negative overhangs in the market are too much for the market to bear.  Bernanke might be able to control interest rates and equity prices, but he has very little power over the actual supply/demand mechanics at work in a market as large and deep as the real estate market.  The government can’t reflate everything.  I highly doubt this scenario plays out.

B.  This is the v-shaped recovery scenario. House prices remain flat to 5% higher in the coming years.  This means the economy has bottomed, labor markets will rebound sharply, wage growth rebounds sharply, demand for housing increases at a better than expected rate, supply does not overwhelm the market, foreclosures are substantially lower than expected, government stimulus continues to aid the private sector, credit problems are entirely a thing of the past, there is no double dip, no recession in 2011 or 2012 and everyone lives happily ever after.   This is the full-blown Ben Bernanke is the greatest Central Banker of all-time scenario.    Even in this scenario I see the overhangs in the housing market continuing to pressure prices.  Prices might rise marginally, but ultimately they remain flat to higher in this fairly optimistic scenario.  Although this scenario is looking more and more likely, I think the removal of government stimulus and continuing weakness in the private sector makes this a low probability outcome.

C.  The “work-out” scenario. House prices decline 7%-15%.  This is the most probable outcome in my opinion.  In this scenario the private sector remains weak, labor markets rebound slowly, wage growth remains tepid, the economy grows below trend, government stimulus stops bolstering markets in 2011/2012, the economy perhaps double dips or re-recessions in 2012, and house prices ultimately succumb to the laws of supply and demand and decline another 15% or so.

D.  The Great Depression 2 scenario. House prices fall 15%-30%.  This too is highly unlikely in my opinion.  In this scenario the credit crisis re-emerges, government spending proves futile, monetary policy proves futile, labor markets retrench, deflation grasps hold of asset prices and the economy grows at well below trend.  I highly doubt the government will allow such a scenario to unfold at this point.  Fiscal policy is likely to remain strong enough to fend off a GD2 scenario.

As I said above, the most likely scenario is the “work-out”.   Government stimulus continues to bolster the private sector in the back half of 2010, but the lack of direct aid in housing begins to weigh on the housing market in the second half of 2010.  Negative seasonal trends make for a very difficult H2 in housing and a tough start in 2011.  The economy appears fairly strong into the latter portion of 2010, but the dwindling stimulus ultimately pressures the private sector.  Demand for housing remains tepid as job growth is weak, the unemployment rate remains above 8% into 2011 and the negative inventory trends prove too much for the real estate market to overcome.  Ultimately, prices decline 7%-15% over the course of the coming 2.5 years.

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