Midday Musings: Housing's Foundation May Be Shaky

The Dow Jones Industrial Average was notably weaker at midday as General Electric(GE Quote) continues to buckle under the weight of yesterday's critique by Pimco's Bill Gross. (American Express(AXP Quote) and 3M(MMM Quote) were also big drags on the Dow.)

But broader market averages were lollygagging near break-even, giving us a chance to revisit everybody's favorite subject: housing.

As detailed in recent columns, the question isn't whether housing and related stocks are in a bubble, but whether it's a bubble akin to Nasdaq circa 1996 or circa 2000.

Recent activity has provided fodder for those who believe in the latter scenario.

Prior to the market's opening today, KB Homes(KBH Quote) reported a whopping 65% increase in first-quarter earnings, which came in at 95 cents a share vs. consensus estimates of 79 cents. In its conference call, the homebuilder raised its forecast for second-quarter earnings to $1.10, from $1.07, and to a range of $6.10 to $6.25 a share for the full year vs. $5.75 to $6.10 previously.

Despite that rosy outlook, and Wall Street's presumed clamoring for earnings growth, KB Homes shares were down 1.7% at midday.

Homebuilders showed a similar inability to rally on good news yesterday, tumbling even though housing starts were reported to have risen 2.8% in February to a seasonally adjusted rate of 1.77 million, the fastest pace in three years. Construction of single-family homes rose 7.4% last month to a seasonally adjusted 1.46 million, the fastest pace in nearly 25 years.

Nevertheless, shares of Lennar (LEN Quote), which posted robust first-quarter earnings of its own, fell 4%. Elsewhere in the sector, Toll Brothers(TOL Quote) stumbled 5.1%, Centex(CTX Quote) shed 5.9%, Pulte Homes(PHM Quote) lost 6.5%, and Ryland Group(RYL Quote)slid 4.3%.

Each was down between 0.4% and 3.3% at midday today, with the exception of Ryland, which was up 0.7%.

"Given the inability of the group to respond to good news [yesterday], we figure these stocks are going to work lower still," John Roque, senior analyst at Arnhold & S. Bleichroeder, commented this morning.

Housing and housing-related stocks have long confounded their skeptics, Roque included. But yesterday's action had more than one observer proclaiming that the long-awaited pricking of the housing bubble was at hand.

"February's extraordinarily strong data suggests to us that housing has hit a ceiling while the economy has hit a floor," commented Donald Straszheim, president of Straszheim Global Advisors in Westwood, Calif. "With the Fed moving its policy stance to neutral and likely tightening by mid-year, rising mortgage rates in the 2002-2003 economic recovery should begin to weaken housing."

Supportive factors such as favorable supply-demand, demographics and recent tax-law changes have led some industry participants and supporters to declare that housing is immune to economic cycles. (Sound familiar?)

"Toll Brothers and the industry as a whole seem to have skipped the recession of 2001 and 2002," Toll Brothers' CFO Joel Rassman recently told Dow Jones. "And the economy is improving, or so we're told, so the best is yet to come."

Phooey, say housing's critics, who note that mortgage rates, which are rising, will ultimately determine housing's fate.

"A good economy will lift incomes, encouraging homebuyers," Straszheim conceded. "But it will also lift mortgage rates, turning 2001's most important positive for house purchases into 2002-2003's most important negative."

In conjunction with bond yields, which had reversed an earlier climb by midday, mortgage rates are rising in anticipation of Fed tightening -- rather than waiting for its actual arrival.

The average 30-year fixed mortgage rate rose to 7.14% for the week ended March 22 vs. 7.08% the prior week, while average 15-year fixed mortgages rose to 6.65% from 6.59%, Freddie Mac (FRE Quote) reported today. Those averages are the highest since the first week of 2002 for 30-year and since the last week of 2001 for 15-year mortgages.

"In this climate, count on housing activity to slow," Straszheim wrote.

Returning to the Nasdaq analogy, tech stocks repeatedly defied the naysayers throughout the late 1990s, though they did suffer myriad sharp corrections. Those downturns unfailingly brought out the "bubble is bursting" crowd, who kept being proved wrong.

The skeptics would be wise to recall those lessons before crying wolf on the housing market. Similarly, housing's advocates shouldn't forget that tech's critics were ultimately vindicated.