Here's what you need to look for to predict a downturn
Economic cycles are like serial killers on a Netflix show: they leave clues to get caught. Interpreting these clues gives you the ability to see when the economy is in recovery and when things are about to go into recession. My job as a data analyst is to provide the map you need to follow these clues, specifically as they relate to housing.
Each economic sector behaves differently in a recession; typically, the industry with the most leverage on growth gets hit the hardest. This was the case for housing during the lead-up to the bubble years as housing data went criminally insane in the years 2002-2005.
As we close in on Thanksgiving, we can be grateful for the recent excellent jobs report, which shows that the housing crash fanatics have failed once again in 2021. But during any economic expansion we can expect to see the occasional red flags warning us of the next economic recession. Some of these flags will just be noise in the system that can be ignored, while others may indicate actual cracks in our foundation that need to be heeded. The trick is being able to distinguish between the two.
Regarding the U.S. housing market, no single metric can herald an oncoming slowdown; it will require several factors signaling in concert for the warning to be meaningful. I’ve outlined these factors below.
First, take COVID-19 data out of the equation
The COVID-caused recession was an anomaly both in its onset and duration. After a decade of slow and steady growth, housing broke out in February of 2020.
Not only did housing data look expansionary, but so did many data lines. Jobs data looked solid, retail sales grew year over year, and manufacturing data was positive again. Economic data, in general, was on an upturn toward the second half of 2019 and the first two months of 2020, only to be slapped down by the COVID-19 brief, but deep, recession.
Traditionally, housing starts and new home sales get weaker before a recession, but we didn’t have time for this to happen before the artificial shutdown of the economy.
Before the COVID-19 shutdowns, from 2008 to 2019, we had the weakest housing recovery ever after the housing bubble burst. Our demographics in the U.S. were both too young and too old to support a vigorous recovery. Sales growth was slow, with many years when new home sales missed expectations. Starting in the year 2020, however, the U.S. began a period (that will run until 2024) when we have the best demographics for home buying ever, which just happened to begin at the same time the economy took a hit due to COVID-19.
Now that we are recovered from a worldwide pandemic — and thanks to our demographics — the housing market has more robust demand than what we saw from 2008 to 2019. During 2020-2024, total home sales (new and existing homes) should be 6.2 million or higher. We are seeing unhealthy price inflation for shelter, not only in home buying but also in rents. Demographics equal demand, and we have a lot of people ages 27-33. I mean, this age group is the biggest ever recorded in U.S. history.
However, I wouldn’t categorize this period as a housing boom. We do not see an explosion expansion in credit or a significant uptick in the number of mortgage buyers as we saw from 2002-2005. With that in mind, you can ignore both the super housing bulls that believe we should be having a construction boom and mega housing bears who think we’re on the verge of a housing bubble collapse back to 2012 levels. Neither of these things will happen.
Look at monthly supply of new homes
With that context in mind, the first sign to look for to indicate that the housing market is slowing is the monthly supply of new homes going over 6.5 months on a three-month average. We saw this happen in late 2018, but at that time, housing starts were low, and housing, in general, was sluggish, so a longer monthly supply just sort of fit into the background.
If that were to happen today in this market, it would be a different story. 2022 will be the first year that housing starts go over 1.5 million. We no longer have a sleepy background of housing activity to hide our signals that the market might be slowing.
The new home sales market is already at 5.7 months of supply, while the existing market is at 2.4 months. Inventory in the new home sales market is more likely to grow as mortgage rates rise than the existing home sales market because this market depends more on mortgage buyers. New homes are also a more expensive product than an existing home, even with the builders’ attempts to balance the difference out in recent years.
This year, we had a spike in monthly supply from a shallow level and got one month of supply at 6.5 months. However, the recent new home sales report showed that the market has stabilized from the recent increase and the three-month average is currently at 6.1 months.
Pay attention to how mortgage rates affect demand
In the summer of 2020, I wrote that mortgage rates over 3.75% could cool housing demand and that we would see weakening demand in the new home sales market first. Once the monthly supply gets over 6.5 months, homebuilders will pull back on single-family housing construction, then multifamily construction, if demand continues to weaken.
Today, mortgage rates are lower than they were in 1990, 2000, and 2008, so don’t think that housing demand will collapse, even if we do get a slowdown. We don’t have a credit boom or a construction boom, so we won’t have a waterfall collapse like what we saw from the peak of 2005.
The biggest concern we have in the current housing market is unhealthy price growth, a problem that is front and center in the new home sales market. I believe the builders did a great job with their margins as they passed on the higher costs of housing for their customers, but they’re mindful of pushing this too much. Remember, we haven’t had rates really rise yet and they’re mindful of what happened back in 2013 and 2018 when rates moved higher.
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