Inspecting Housing's Foundation for Flaws

Reports of the real estate bubble's demise have persistently proven to be premature. Some folks, notably Federal Reserve Chairman Alan Greenspan, even dispute the notion a real estate bubble exists.

But recent weakness in housing stats suggests the winning combination of cheap borrowing and rapid price increases finally may be coming to an end. Such a change in sentiment, should it persist, has widespread implications for the economy and some of the market's best-performing sectors, including the still-hot homebuilders.

"Regrettably, we are witnessing a replay of the late-1990s telecommunications and technology boom-and-bust experience, where a surfeit of speculative finance fosters destabilizing overspending in the 'hot' sectors," writes Doug Noland, market strategist at David Tice & Associates, managers of the (BEARX Quote)Prudent Bear fund.

Admittedly, Noland is among those skeptics who've been fruitlessly searching for the end of the housing boom for some time. But early warning signs may be emerging: While the S&P 500 gained 0.6% in the week prior to Wednesday's setback, real estate companies such as WCI Communities (WCI Quote) and St. Joe (JOE Quote) lost over 4% each, and the industry group fell about 1%, according to Morningstar. Meanwhile, real estate investment trusts (REITs) lost 3.5%.

The recent weakness could be a harbinger for the housing sector, but still left real estate up 16% year to date and REITs up by 12.1%; enviable gains compared with the S&P's less-than 1% advance.

Huffing and Puffing

The entire residential real estate sector has been fueled for the past few years by rising prices and falling interest rates. High home prices have encouraged quick sales and prompted lenders to open the spigots. Lower interest rates increase demand by making homes more affordable, attracting first-time buyers and converting renters to owners. Mortgage debt stands at a record $6.8 trillion.

Celia Chen, director of housing economics at Economy.com, says housing sales may remain strong for another month or two, but should slow substantially by year-end as mortgage rates tick up and the furious pace of the past few years leaves fewer and fewer buyers. Indeed, evidence is starting to emerge that robust trends in housing are starting to falter.