MARKET RECAP

After getting off to a rough start in 2011, the data on housing has continued to turn for the better. This past week, Clear Capital’s home price index showed that prices stopped declining in early January and increased for the first time since August. The change in prices, especially during a point in the year when sales are slow, is a sign that demand is returning. Even more encouraging, Clear Capital said that the slowing rate of sales of REO properties was the main reason for the price increase.

REO properties remain a market concern. We are all familiar with the distressed property overhang that weighs on prices. Clear Capital reports that in the fourth quarter of 2010, REO saturation increased 1.4 percent, but that is actually a drop from the 3.2 percent increase posted in the previous period. If the deceleration trend continues, Clear Capital says, home prices could be poised for future gains.

Of course, not everyone is on board with a rising-price environment. Fiserv expects home prices to decline another 5.5 percent nationally in 2011, though Fiserv also notes that three-fourths of the 375 metro areas it tracks will see prices stabilize by the end of the year, with all markets stabilizing by the end of 2012.

Our view continues to support more price-stabilization, with rising prices in certain locales. In fact, we expect that the most over built locales – Las Vegas , Phoenix , Central Florida – will see the most pricing improvement. There is no science behind our prognostication, just common sense. The sun-and-sand areas are still desirable, and they’ve suffered the most price depreciation since the financial crises began in 2007. We expect that they will likely post the best percentage improvement – albeit because they are coming over a very low base.

Mortgage rates moved off a very low base in the waning months of 2010, but they continue to hold steady, in that the prime 30-year fixed rate loan is still hovering in the 5-percent vicinity. Rates are better on some days than others, to be sure, but that’s usually due to a surge in Treasury-security activity, which occurs when investors panic over some conflagration in a distant part of the world, most recently in Egypt .

However, conflagrations fade quickly and rates return to domestic influences, with inflation being the strongest influence. Price inflation is readily evident in oil, which has risen to over $100-a-barrel. Meld rising oil prices with growing consumer demand for all goods and services (an outgrowth of an improving economy) and an extraordinarily large money base and we are looking at the potential for wide-spread price inflation (which, by the way, will eventually become evident in housing prices).

The Power of Optimism

Our bias is toward optimism, and not because we like to indulge in wishful thinking. An optimistic outlook focuses the mind on searching for opportunities, which also tends to make obstacles that much easier to clear.

For the past year, we’ve been saying that opportunities abound: home prices are low, mortgage rates are low, the economy is recovering. That’s good and bad news. Good in that the economy is improving, bad in that the best deals are fading away. For those with the courage to buy or invest when the popular financial media are predicting the end of the word (and fewer in the media are doing that these days), the rewards nearly always pan out over time.

And time is a key factor to focus on; real estate isn’t about flipping, which is a niche market for sharp-penciled types who are obsessive about time-management, contractor-oversight, and cost control. Most of us aren’t obsessive. But real estate still works. The key is to get in at a low-base price and finance at a low interest rate; positive cash flow is easier to generate (for investors) and price appreciation will likely be realized when it comes time to sell.

Deals are still available if you are willing to seek them in negative situations, because the long-run opportunities don’t avail themselves when the outlook is the sunniest. Today, pessimistic commentators continue to lament what the foreclosure overhang is doing to the market. The optimistic actor, meanwhile, continues to focus on the opportunities the overhang is creating, because he knows the overhang and the opportunities will not last forever.

MARKET RECAP

We hope we see marked improvement in the home-builder sentiment index on its next release, because the news on new home sales in December was better than just about anyone expected, jumping 18 percent to an annual unit rate of 329,000. What’s more, supply came down and prices jumped. The former fell to 6.9 months, versus 8.4 months in November, and the latter jumped 12 percent to a median $241,500.

We did say “marked” and not “phenomenal.” As encouraging as the news on new-home sales was, it wasn’t perfect. The fall off in purchase applications over the past few weeks points to a fall off in new-home sales for January. In addition, much of the improvement was concentrated in the West, not evenly distributed throughout the regions. Then again, it rarely is. Real estate is, after all, local.

Overall, though, we remain encouraged. This and the previous week’s existing-home sales report is good news for housing. Now it’s a matter of seeing if the winning streak can be strengthened and extended.

Some in the financial media speculated that the buying rush was tied to December’s jump in mortgage rates, which encouraged home shoppers to hop off the fence and act. We tend to agree with the speculators. We’ve been saying over the past half-year that rising rates would be more stimulative than dissuasive. Expecting lower prices and then getting them over an extended period lulled people into an unwarranted sense of certainty and nonchalance. The rate hikes over the past two months have shocked the market back to reality and motivated many people to act.

Another shock could be forthcoming for price-deflation proponents. The S&P/Case-Shiller home price index showed a year-over-year price decline in November, with a 0.4 percent decline for the composite 10 index and an adjusted 1.6 percent decline for the composite 20 index. David Blitzer, chairman of the index committee at S&P, warned that “A double-dip could be confirmed before Spring.” Blitzer defined a double-dip as both the 10- and 20-city composite indexes setting new post-peak lows.

We are not so sure in light of December’s data on median home prices. There is also the issue of money supply, which has increased dramatically over the past two years and is set to continue increasing this year. The Federal Reserve is confident it can manage any spike in inflation, but we remain circumspect. Inflation often works like pouring a new bottle of ketchup: You keep smacking the bottom of the bottle repeatedly and nothing comes out. You smack it again and find you have ketchup (and price increases) all over the place.

The prospect of sudden inflation is a primary reason we continually warn borrowers and buyers not to procrastinate. Mortgage rates continue to hold steady, and to us, that’s an opportunity to act. However, the 30-year fixed-rate loan continues to parallel movement in the 10-year Treasury note, and the 10-year Treasury yield is itching to move higher.

Money on the Move

Correlations between asset classes are always on the move and always changing: when one asset class gets hot, the others tend to cool. In case no one has noticed, the stock market is hot these days. In fact, the two leading stock-market benchmarks – the Dow Jones Industrial Average and the S&P 500 Index – are posting multi-year highs.

We broach this point to note that money invariably moves to the hot asset class, and in today’s market, that’s stocks. This money also invariable moves at the expense of the former hot asset class, and the former hot asset class is Treasury securities. As money leaves an asset class, the required expected return on that class rises to reflect its diminishing popularity and to entice money to return.

As we noted above, mortgage rates are tethered to Treasury rates. We also noted that inflation would get rates moving higher, but so will money moving away from Treasury securities into other asset classes. We think this notion of asset rotation is one more arrow in the quiver of those of us expecting higher mortgage rates in 2011.

MARKET RECAP

The economic news stumbled out of the gate this week when the Commerce Department reported that homebuilders began work on the second fewest number of homes in more than fifty years in 2010, breaking ground on only 587,600 homes. Of course, the first fewest was the year before, 2009, when they broke ground on 554,000 homes, so there was an improvement.

The news quickly regained its footing, though. Builders appear to be planning more projects in 2011, based on permits rising 16.7 percent in December to a seasonally adjusted annual rate of 635,000 units, the best pace since last March. Fannie Mae is even more optimistic. It expects overall starts to increase 17.3 percent and hit 710,000 units this year, with another 42 percent increase to 1.1 million units in 2012, followed by a 42 percent gain to 1.5 million units in 2013.

As for the existing home market, RE/MAX reported a 13.2 percent increase in December sales. More encouraging, crisis hotspots Arizona and Florida produced double-digit yearly gains, proving once again the ironclad law of economics – lower prices equal more demand. According to RE/MAX CEO Margaret Kelly, “December’s trends put the housing market in a strong position for growth as the home shopping season nears.”

The NAR corroborated RE/MAX’s bullish outlook with bullish data of its own. The NAR reported that existing house sales increased 12 percent to a 5.28-million annual rate in December. Moreover, the number of homes on the market dropped 4.2 percent to 3.56 million units. At the current sales pace, it would take 8.1 months to sell these houses compared with 9.5 months at the end of November. An eight-to-nine month supply is considered consistent with stable prices.

Stable prices have been the defining characteristic of the mortgage market so far in 2011. The prime 30-year fixed-rate loan has been holding around 5 percent, vacillating only a few basis points in either direction. However, rates could be pressured higher if China continues to sell US government debt, particularly 10-year Treasury notes. Mortgage rates aren’t directly tied to 10-year Treasury notes, but these instruments hold tremendous sway over the direction of long-term debt instruments, including mortgage-backed securities.

Therefore, it’s worth repeating that although mortgage rates are off November’s lows, they’re still historically low. We doubt lower rates are in our future, and we are unsure how long price stability will last. At this point, we simply cannot offer any sound economic reason for people to wait on a refinance or a home purchase.

The Economy is More Than the Consumer.

Economists expend a lot of time and energy analyzing the consumer. It’s understandable, given that personal consumption represents 70 percent of gross domestic product. However, GDP only measures the value of final output. It deliberately leaves out a big chunk of the economy – namely intermediate production or goods-in-process at the commodity, manufacturing, and wholesale stages.

A more thorough accounting of total spending at all stages actually doubles GDP. By this measure, the consumer represents only 30 percent of the economy, while business investment (including intermediate output) represents over 50 percent. In other words, businesses stimulate the economy as much, if not more so, than consumers.

Businesses make decisions based on two factors: current consumption and expected future consumption. We often forget the latter, which businesses gear up for by purchasing commodities, capital equipment and workers’ services ahead of consumer sales. Therefore, while consumer spending might lag at the time, that doesn’t mean the economy is lagging too. The good news is that business spending has been strong over the past few months, which we think portends better things for 2011.

MARKET RECAP

The beginning of the year always produces a flood of opinion on what the next 12 months will bring. Much of the opinion is simply an extrapolation on what was occurring in the closing months of the old year. Nevertheless, some of the prognostications are worth vetting just to get an idea of market sentiment.

RealtyTrac continues to forecast pessimism. Last year lenders filed a record 3.8 million foreclosures, and RealtyTrac doubts that the peak has been reached. In fact, it doesn’t expect the trend to reverse until 2012. Resubmissions are one variable in RealtyTrac’s cloudy outlook. The company expects as many as 250,000 foreclosures will be resubmitted this year because of the mortgage-servicing scandal that occurred in the fourth quarter of 2010. The continued foreclosure glut, according to RealtyTrac, will shave another 5 percent off average home prices this year.

A little perspective is in order: We need to consider that more than half the foreclosures last year originated in a handful of states – California, Florida, Arizona, Illinois, and Michigan. These select burgs have seen home prices plunge sharply, unemployment rise sharply, or a combination of the two. Nevertheless, real estate is local. Toss out the negative outliers and the data look a lot better. The problem is, too many borrowers and buyers focus on the national numbers, which tend to skew impressions of the local real estate market.

RealtyTrac’s negative forecast on foreclosures and home prices overshadowed the National Association of Home Builders’ forecast for starts to climb 21 percent this year to 575,000 annual units. Granted, that’s less than a third of the starts that occurred during the market peak in 2006, but we could argue that many of those homes shouldn’t have been built. Working down excess inventory takes time, and last year’s winter spike in starts was simply demand riding forward on the back of federal tax credits. The market today is more attuned to economic reality.

We still believe rising mortgage rates are the economic reality for 2011. Price inflation is kicking in, as most of us empirically know after a visit to the grocery store and the gas station. The official numbers also support our observation. The December producer price index rose 1.1 percent, the most in 11 months. An improving outlook and rising demand in fast-growing markets like China mean producers are paying more for raw materials. These costs will eventually be passed on to the rest of us, if they haven’t been already.

Higher interest-rate pressure is also percolating within the Federal Reserve. Directors from the banks in Dallas and Kansas City want to increase the discount rate – the rate banks borrow from the Fed – by 25 basis points. In addition, the minutes from the Fed’s most recent meeting noted, “positive developments indicated the recovery was continuing.” A continuing recovery means continuing inflationary pressure.

Meanwhile, mortgage rates are holding steady after their run up into the new year. We think that presents an opportunity for borrowers to refinance or make a purchase before inflation pushes rates higher.

Why Real Estate?

Everyone likes real estate, whether what’s constructed on it serves as an abode or an investment. Real estate is tangible. Unlike stocks and bonds, real estate can be touched, handled and improved. Real estate provides “psychic revenue.” There is a pride of ownership that comes with real property that doesn’t come with other property.

Financial media are rife with articles on why owning residential real estate isn’t such a good idea. They point to arguments on how real estate decreases mobility or how much it costs to maintain. The articles have some validity, but they are often marked by glaring omissions. Yes, real estate can limit mobility in a slow economy, but it has always been that way. There is nothing new to this point.

Most of us have rented and owned residential real estate; we would argue that most of us prefer to own. When we own our house, it feels like a home – that’s the psychic revenue. Value matters, to be sure, but if the scales are close after weighing the renting/owning choice, they still tend to tilt toward owning. It’s important to keep that preference in mind when others are trying to convince us otherwise.

MARKET RECAP

Home prices are the leading concern as we begin the new year. Clear Capital reports that prices dropped 4.1 percent across the nation in 2010, and it was a volatile decline at that. Values declined 5.3 percent over the first 12 weeks of the year, then spiked 9.7 percent through mid-August, only to drop 9.4 percent through year’s end. Clear Capital sees prices dropping another 3.9 percent through 2011.

Another analytics firm, Altos Research, also reports less-than-encouraging pricing news. According to Altos, home prices dropped 1.6 percent in December, with new listings actually hitting the market lower than that. The good news from Altos is that prices will “likely” increase modestly as we head into the spring season. Shadow inventory remains a concern, but Altos reports that inventories were cut nearly 6 percent in the 10 largest markets in December.

The latest spat of negative data doesn’t mean we should throw in the towel on price stability, or that buyers should wait for lower prices before taking the dive into the housing pool. The heavy across-the-board discounting is over. Changes in prices going forward will be incremental and specific to local markets – some markets will see additional discounting, some won’t.

What’s more, markets are dynamic: money saved from any additional discounting could easily be offset by mortgage-rate increases. Goldman Sachs expects that the Federal Reserve will end its second round of quantitative easing in June, and that 10-year Treasury yields (a benchmark for 30-year mortgage rates) will climb to 3.75 percent by year-end, and then advance to 4.25 percent by the close of 2012. The historical average spread between a prime 30-year fixed-rate mortgage and the 10-year Treasury note is around two percentage points, which means if Goldman Sachs proves accurate on its prediction, we could be looking at 5.75 percent 30-year loans this year and 6.25 percent loans in 2012.

Of course, a forecast is no sure thing. In fact, forecasts are often wrong, but there are mitigating circumstances to consider. A majority of top decision-makers at the Federal Reserve believe that concerns over falling prices have eased and that inflation will gradually rise. Recent data support that belief: employment is improving – ADP Employer Services reports that 297,000 new private-sector jobs were created in December, triple the consensus estimate; manufacturing has expanded for 17-consecutive months; stocks continue to trend up; and rising food, energy, and commodity prices are stoking inflation fears.

Our advice remains the same as it has for the past two months: get the mortgage application in, and, unless you have a strong gambler’s constitution, lock instead of playing the floating-rate game. We don’t think borrowers will be giving up much. Let’s remember that we are still within 50-basis points of a 50-year low.

Let’s Not Forget the Other Half

Actually, it’s much more than half. Most media accounts are peppered with sad stories of people who are under water or who are facing foreclosure because of job loss or because they simply took on too much house and too much financing. The fact is that the vast majority of mortgagors have a job and are current on their payments.

Many of these folks are underwater, to be sure, but most are not, so there is still plenty of opportunity for plenty of people to buy, invest, or sell. While there is currently some slack in demand, reduced prices and low interest rates should keep home purchases attractive. The market is now simply waiting on a robust recovery – most likely lead by job growth – to spur consumers into taking advantage of very affordable conditions.

A strong recovery appears to be at least a year, or possibly two, away. But as we’ve stated, if we wait for a strong recovery to be in full force, the bargains (and the low financing rates) will be gone. That’s a lesson worth imparting to the half that is still fearful of the recent past or needs a consensus backing it before it will act.

MARKET RECAP

Thank goodness for small favors, such as a work-shortened, holiday-spirit-infused season. Why are we so appreciative? The housing news hasn’t been particularly encouraging, and hardly agreeable to a festive spirit.

Much attention, and even more lamenting, was poured on Tuesday’s release of the S&P/Case-Shiller index of home prices. In short, the seasonally adjusted 20-city aggregate fell 1.0 percent in October from September, posting a fourth-consecutive monthly decline to leave the index down 0.8 percent from October 2009.

The news on home prices was ill received, to say the least. Hopes of a recovery shifted to despair over the likelihood of a double-dip in prices. In fact, most economists see prices continuing to decline, with most estimates congregating in the mid-single-digit pews. The economists at A. Gary Shilling & Co. gained some notoriety with an exceedingly bearish outlook, predicting home prices will drop another 20 percent before hitting bottom.

The prospect of another wave of foreclosures is the reason so many are so negative. There were 1.2 million homes in the foreclosure process as of the end of the third quarter, up 4.5 percent from the second quarter, and up 10.1 percent from a year ago, according to the Office of Thrift Supervision. Regulators stated that the surge in activity was due to banks having “exhausted” options for keeping many delinquent borrowers in their homes.

Foreclosures add to inventory, and swelling inventory is the enemy of pricing. Shilling & Co. notes that “even a 5 percent fall in home prices will push an extra 8 million homes into negative equity with risk of millions walking away from their homes.” Does this mean that 2011 is setting up to be an annus horribilis on par with, if not worse than, 2009?

Before we all close up shop and head for the hills, a few points are worth considering. First, The Office of the Comptroller of the Currency reports that though banks have picked up the pace of foreclosures to get through their backlog, over 87 percent of the 33.3 million loans in the banks’ portfolios were current and performing at the end of the third quarter. Second, the data are three-months old, and that includes the Case-Shiller pricing data. A lot can happen in three months. Third, the economy and the labor markets are improving, which tempers the temptation to walk away from a home over negative equity.

The last consideration – labor and economy – is the most encouraging and is reflected in rising mortgage rates, which are up nearly 60-basis points over the past two months. We’ve stated many times that rising interest rates are often reflective of economic vigor, and vigor is a byproduct of confidence.

Despite the possibility – and even the anticipation – of falling home prices, the environment is still favorable, by historical measures, for borrowing at low rates and buying at low prices. What’s more, continued low prices aren’t a given: when most economists anticipate something, the likelihood rises that what is being anticipated has already occurred.

The Stock Market Analogy

If we look back to the stock market after the bursting of the Internet bubble, in late 2000, we can draw comparisons to the bursting of the housing bubble. The Dow Jones Industrial Average hit a post-bubble low roughly two years after the bubble burst. From its 2002 lows, the DJIA increased steadily, until the bursting of the housing bubble, in early 2008, which still puts the DJIA up over 35 percent over the past eight years.

Looking at housing: prices are off over 30 percent nationally since the market’s apex in 2006, sentiment has turned sour (a positive contrarian indicator), and the market is yearning for a reason to be optimistic. The analogy might not be perfect, but the scenario is similar to the DJIA circa 2002.

Like the return of the stock market, the return of the housing market will be predicated on confidence. The minute Americans see a real reason for hope – an expanding economy and brighter job prospects, for instance – housing will come roaring back. But it won’t come roaring back in a linear, predictable fashion; markets never do.

MARKET RECAP

The latest housing data are raising optimism. Existing home sales rose 5.6 percent in November to a seasonally adjusted annual rate of 4.68 million units. More encouraging, prices didn’t soften to stimulate sales. To the contrary, they rose, with prices up slightly to a median of $170,600, thus ending a nearly six-month run of declines. As for the number of homes on the market, supply fell for a third-straight month and is down to 9.5 months.

The news on new homes wasn’t quite as cheery, but affirming nonetheless. The Commerce Department reported sales increased 5.5 percent to a seasonally adjusted 290,000 annual rate in November, while supply of new homes on the market fell to 8.2 months’ worth, mostly because fewer homes were built. But those that were built were fetching a better price. The median sales price for a new home increased 8.0 percent, to $213,000, in November.

In addition to the NAR and Commerce Department reporting better home prices, the Federal Housing Finance Agency reported that prices rose 0.7 percent in October. Most market watchers (us included) were expecting a slight drop, especially after all the alarming news on foreclosures, distressed sales, and negative equity that has flooded the markets in the past two months.

All things considered, the news, when aggregated, suggests to us that we are close to being out of the woods, though not everyone agrees. A few economists think that price discounting will continue at least for another year. MacroMarkets surveyed a panel of economists and the consensus was that national home prices would not increase year-over-year until the fourth quarter of 2012. Specifically, they expect prices to remain 0.17 percent below where they will end in 2011. Farther down the road, they see rays of light: by 2015, prices, the economists say, will increase by more than 3.5 percent from wherever they will end in 2014.

We can’t help but question the validity of MacroMarkets’ survey; the numbers are simply ridiculously precise. It would be like us saying that mortgage rates will be 47.3 basis-points higher at the end of 2011 than they will be at the end of 2010, even though we have no idea what the exact rates will be a week from now. For us to say that the 30-year fixed-rate mortgage will average over 6.5 percent in 2015 is no less foolish. There is no way to know.

The best anyone can do (at least to be believable) is to talk in generalities, and generally we think mortgage rates will end 2011 higher than they will end in 2010. How much higher? Fifty basis points seems reasonable, given the outlook for money supply, budget deficits, and economic activity. A full percentage point seems within the realm of possibilities as well. Could rates go lower? Sure, but we think the odds favor higher rates. We just don’t have a specific number for those odds.

In the meantime, we know where we stand now: in a more volatile mortgage-rate environment, with rates trending higher. We did experience a slight pullback this past week, but we don’t expect the pullback to instigate a new trend in lower rates.

Don’t Fear Rising Mortgage Rates

The most invoked argument against higher mortgage rates is that they lower the home affordability index. It’s a legitimate argument, to be sure, in that mortgage interest is a significant cost of homeownership.

But there are other factors to consider: Rising rates spur people to action, something we’ve been saying for the past six months that is showing some validity. Campbell/Inside Mortgage Finance surveyed 3,000 real estate agents nationwide on homebuyer activity and found a jump in first-time homebuyer purchases in November over October. The principal reason for the jump was nervousness over rates going higher still, which motivated many fence sitters to act.

It is also worth noting – again – that higher interest rates reflect an improving economy and greater economic activity, which are, in turn, indicative of higher employment and higher wage rates. So even though the interest-expense component of the home affordability index might rise, it will be offset by more employment and rising incomes, which means more people can afford a higher-cost home. That’s not such a bad thing.