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Mortgage applications are a useful gauge of housing demand. For the week of June 23, total mortgage applications dropped 7% from the week before and were down 31% from the same week a year ago, according to the Mortgage Banker’s Association (MBA). The biggest drop was refinancings, down a whopping 46.4% in a year, reflecting the impact of rising rates on consumers. Two weeks later, total mortgage applications were down 36.3% and refinancings had dropped 52% from the previous year.

Housing represented 34% of household assets at the end of 2005, nearly one and a half times the 24% of household assets at the start of 2000, according to Moody's Economy.com. This would evaporate quickly in the event of a sizable downturn in property markets, imparting a more serious impact than the bear market of 2000-2002.

Figure 9 – A weekly chart of the S&P Homebuilding Select Index shows homebuilders falling out of bed between April and July 2006. Note the bearish head-and-shoulders top pattern with the break of the neckline in April that gave traders the warning. Between the July 20, 2005, peak and July 14, 2006, the index shed more than 46%. Chart – Tradestation.com.

Pressure Point 4: Expanding unsold home inventories
A question that has been bandied about in the last year is whether there will be a soft or hard landing in property markets. Housing inventories provide part of the answer. Through 2006 inventories of both new and existing homes have grown to all-time highs. In July, existing home inventories rose 3.7% from June, hitting 2.751 million, the highest level since May 1988. There are approximately 565,000 unsold new homes. According to the National Association of Realtors, this represents an all-time high in existing home inventories since records began in 1982. As sales slow, this will grow expanding inventories increase the probability of a hard landing.

Excellent leading indicators of the real estate market are homebuilder’s indexes such as the S&P Homebuilding Select (Figure 9) and the Philadelphia Housing Index (HGX). Like the lamb in the famous nursery rhyme, where homebuilders go, the rest of the real estate market and prices are sure to follow.

Connecting the housing dots
We are in the very early stages of a property correction in North America that could last five years or longer so the pain is just beginning. Even an average drop in real estate prices of 20% across the nation would mean a loss of $3.8 trillion. Prices in many parts of Florida are already down that much, and some analysts are calling for drops of between 40% and 60% over the next five years.

Raymond James analyst Rick Murray sees a number of factors including affordability, excess inventories, orders and use of incentives at levels that are similar or worse to those that existed in 1980 before the last big crash. Aggressive lending practices by banks have put lenders at the greatest exposure to the real estate sector than at any time since WW II. The economy has grown more dependent on real estate than at any time in recent memory, so any correction would have a widespread economic impact.

Economic dependence on real estate means that as markets slow, jobs are being lost and consumer spending slows as the source of cheap funds (and well-paying jobs) dries up. As job losses mount, further declines in consumer spending result in a negative feedback loop. Add record levels of debt and the highest real estate prices in history to the mix means that prices have a long way to drop, and heavy debt burdens will speed their descent.

Real Average Hourly Earnings Growth: Where’s the beef?
Something that has been strangely absent so far in the latest economic recovery is real growth in average hourly earnings (hourly earnings less inflation). As Figure 10 shows, growth has slowly but steadily declined since 1965. After peaking in 2002, hourly earnings dropped steadily into negative territory in early 2004 and remained negative for most of the next two years. Wage growth has remained anemic through 2006 so far.

As noted, economic prosperity has been carried on the back of rising mortgage equity, the lowest interest rates in decades and tax breaks. If this economic recovery is to last, it must be accompanied by real wage growth that has yet to materialize.

In his book Ahead of the Curve, Joe Ellis makes a strong case for the relationship between wage growth peaks and bear markets. Red arrows in Figure 10 show past earnings peaks and grey rectangles, the bear markets that often ensued. Black boxes are past recessions. Bear markets have been delayed in the past by fiscal events such as tax breaks and, more recently, the ready access to cheap money, thanks to appreciating home values.