Tool Time?

Chris Pavese's picture

Believe it or not, all of the officials at the Fed are not quite as blind as Bubble Blowing Ben. The
Dallas Fed, run by our hands-down favorite Fed President Richard
Fisher, publishes a regular Economic Letter that is always insightful
and lacks the bias of certain other elected officials whose Helicopters
will remain nameless.  We’d recommend those expecting a strong rebound
in housing anytime soon, take a look at the December 2010 issue titled The Fallacy of a Pain-Free Path to a Healthy Housing Market.  Mean reversion is a powerful force in finance and a picture is worth a thousand words.

As gauged by an aggregate of housing
indexes dating to 1890, real home prices rose 85 percent to their
highest level in August 2006. They have since declined 33 percent,
falling short of most predictions for a cumulative correction of at
least 40 percent.[1] In fact, home prices still must fall 23 percent if
they are to revert to their long-term mean.

With this picture in mind, we were
particularly interested in another report recently issued by the Joint
Center for Housing Studies of Harvard University, titled A New Decade of Growth for Remodeling
While the authors of the report are mildly bullish on the outlook for
home improvement, we find it exceptionally difficult to get remotely
excited about the industry, when comparing the chart above, to the one
below.  The bottom line is simple – further declines in home prices, a
near certainty based on a multitude of factors, portends further
weakness in home improvement and remodeling spending.

We’ve come across several other reports
on the industry with a modest bullish bias based upon a handful of
arguments (some better than others).  We consider many of these factors
potential positives for the likes of HD and LOW, but find little to get
excited about with respect to more niche players in the industry (LL). 
For example, one analyst points to the fact that a greater portion of
home improvement spending is non-discretionary maintenance and repair
versus more discretionary remodeling expenditures.  “If a window breaks,
it needs to be fixed; snow needs to be shoveled and leaves need to be
raked.”  We wonder how many floors “break” as homes age?  This trend
towards “needs” and away from “wants” bodes favorably for HD/LOW
relative to LL.

“The Street” also correctly identifies
that ticket trends have been supported by small project spending. 
Importantly, home prices are a key link to ticket trends since excess
home equity has been a key source of larger project related spending
(i.e. flooring).  The year-over-year change in HD and LOW average ticket
has exhibited a close correlation (the r-squared since 2002 has been
0.78) to home price changes.  However, with most analysts modeling only a
“modest” further decline in home prices, we think the downside in the
industry is significant, should prices fall further toward the long term
average.  Again, we encourage you to read the full report from the
Dallas Fed (link above) to understand the multitude of factors which
make a greater decline in housing our base case.  In any event, we would
argue that even the “bullish” outlook on small project spending is yet
another potential positive for HD/LOW but does little for those
companies in the space focused solely on flooring (LL), which is quite a
large ticket, particularly when discretionary income is increasingly
soaked up at the gas pump.

But at the end of the day, we see more
downside risk from these levels, particularly for more speculative
stocks in the space (LL) that are priced for perfection:

  • Historically, there has been a close correlation between
    mortgage rates and housing turnover.  Compliments of QE2, potential
    home buyers are unlikely to come out of the woodworks given the
    spike in mortgage rates since last summer.  Less
    turnover means less home improvement spending as the lion’s share
    of dollars in the space are spent by homeowners within their first
    two years of ownership
  • Homeownership rates and the number
    of homeowners have declined and are likely to continue their
    descent given demographic constraints and the threat of much higher
    interest rates in the years ahead.  The
    upward trend in home improvement spending in the decade leading up
    to the bubble was largely driven by reckless domestic policy which
    encouraged homeownership at any cost.

    Since homeowners spend more on improvements that renters, the
    reversal of this trend should turn this tailwind into a formidable
    headwind until homeownership levels revert back to more normal levels

  • Spending on home improvement has been fairly concentrated among a
    relatively small number of metropolitan areas with the top 35 markets
    accounting for nearly 55% of all spending.  It turns out that bubbly
    house prices have been a key determinant of these expenditures. As
    the housing bust and subsequent recession have been more severe in
    these markets (you know who you are), unemployment is likely to linger
    at structurally higher levels, while a greater percentage of homeowners
    are underwater on their mortgages.
    just say the largest spenders on home improvement are not exactly
    running out to dump more money into homes worth less that what they owe
    and still falling in value

We discussed the risks of potenital dumping duties on Chinese imported engineered flooring in our original report, titled Got Wood?
We encourage those invested in the flooring industry to take a close
look at this analysis, as the risk is real, despite being
underappreciated on “the street” and downplayed by management.  Given
the potential combination of Housing Headwinds and Potent Protectionism,
we wonder who exactly is buying shares of LL near 30x earnings.  For
what it’s worth, it would seem that at least one other shareholder
agrees with our assessment – Chairman and Founder, Tom Sullivan,
has sold approximately 75% of his ownership stake since going public in
2007.  As another pioneer in the industry would say, “Haauh?“

Disclosure: At the time of
publication, the author was short Lumber Liquidators  (LL), although
positions may change at any time.

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Herman Strandschnecke's picture

 In europe we would call this a Shed. Lol.

apberusdisvet's picture

2 X median HH income will be the bottom; still way too much risk at 3X.  As median HH income keeps falling, the outlook is not so good.  BTW those 10 million vacant homes are probbably now worth shit, especially in sand states; anyone have a bulldozer to rent?

eddiebe's picture

It should'nt take a phd to understand that stagnant wages and rising cost of housing( along with rising energy, medical. education what else?)  can co-exist for long. Now we are starting to see the results of what happens when too much cream is being skimmed off the top. Keep skimming and pretty soon you scrape bottom.

TeMpTeK's picture

Just today the lady across the street told me shes waiting for home prices to go back up again so she can sell....... I told her to put it in her will.

Pemaquid's picture

My money goes on home prices falling more than 23%.  Why?  High unemployment and a shit economy. 

topcallingtroll's picture

Print faster, Ben. Housing forms a base with another ten percent drop. Inflation brings everything up a notch, and you start slowly letting off the liquidity pedal as we ease to a perfect stop without putting on the brakes. Brakes are dangerous right now.

Drag Racer's picture

Just a note on home improvement numbers...

My brother is a small general contractor in Los Angeles. 6 months ago he was doing quite well and had more business than he could handle. We discussed this a bit as he was curious as to why he was doing well as the general housing market was dismal. Our conclusion was many of the larger contractor have closed up due to the dead housing starts therefore opening up the remaining demand to the little guys.

Since late Oct. bisiness started to dry up and is getting worse rapidly. My brother said the only people spending now are from the 'massive' influx of Asians.(Chinese/Arabic) Since they tend to only do business with, for the most part, their own race, my brother said things are not looking good.

bronzie's picture

"At the time of publication, the author was short Lumber Liquidators  (LL)"

this 'article' is mostly a hit piece against LL

everyone is talking their book but this fluff piece is blatant

Panafrican Funktron Robot's picture

If you accept the concept that 3x average household income is the stable average value of houses, it looks like we have another 12% to go on the down slope to reach sustainable valuations (currently around $170K, average income is around 50K, ergo home valuation needs to go to $150K).  Some metro markets are pretty close to hitting this already, some still have a ways to go.  I don't expect a material uptick in property valuation until this number is hit. 

Of course, this is all in nominal terms.  In real terms.... that's really something I don't even desire to think about, the cog dis pain is too much to handle. 

topcallingtroll's picture

Just never look at the house you bought in real terms. It's just a place to sleep and crap in. My wife made me buy at the peak too. Fortunately i live in a shitty industrial town so peak wasnt too bad.

Optimusprime's picture

There are those of us who actually built our own homes.  You know, felling trees, bandsawing timbers and boards, taking time off from the rat race to actually do something productive.  Let me tell you, for people like us, our house is a home, not a "place to sleep and crap in."  You have my sympathy.

DOT's picture

You got the will and the skill.

I'll bet your home is also free and clear of Banker Bondage.

Careless Whisper's picture

lacks the bias of certain other elected officials whose Helicopters will remain nameless

nobody elected mister helicopter! he isn't accountable to 'we the people'. his mission is to help the international banks that own the private federal reserve. how can you have a "hands down favorite" member of those central bankers?


Doctor sahab's picture

is it too late to flip my house?