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Shelter Glut Could Prove to Be Bubble's Demise

Like most overextended asset classes, housing's inventory is starting to build up.
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Like it or not, most asset bubbles end the same way.

Back in 2000, the first signs of trouble surfaced when various tech-related firms grudgingly began to report overcapacity. After years of exponential growth, inventories were building faster than they were going out the door, which is to say, faster than consumers were consuming end-products.

In that respect, Thursday's report on January housing starts, which is a good indicator for inventories of new homes coming on the market, might shed some light on the state of the housing bubble.

Economists on average expect that construction started on an annualized 2.023 million new homes last month, compared with 1.933 million in December, according to a


poll. Warmer-than-usual weather has helped homebuilders in January, just as it helped employment and consumption, economists believe.

Some may celebrate the pickup in housing starts as a sign that housing is cooling slowly, ensuring that the vast amounts of wealth consumers have been drawing out from ever-rising equities over the past few years won't disappear overnight.

In fact, all it means is that the inventories of new homes is going to get larger. How about demand?

On Tuesday, star homebuilder

KB Home

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warned of an increase in the number of canceled home orders and of a drop in new-home sales in the first two months of the year. Likewise,

Toll Brothers

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last week warned that new orders for homes had dropped by 21% in the first quarter so far.

And the mood remains gloomy in the industry. On Wednesday, the National Association of Home Builders (NAHB) said its housing market index remained at a two-year low of 57 in February. Both the NAHB's buyers traffic index and its future expectations index dropped by a point.

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Federal Reserve

Chairman Ben Bernanke, meanwhile, sought to be reassuring about the housing market during his first official testimony to Congress on Wednesday. "A leveling out or a modest softening of housing activity seems more likely than a sharp contraction," he said.

He did warn that "slower growth in home equity, in turn, might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated." This, Bernanke went on, was one of the main risks to the Fed's upbeat assessment that the economy will grow at a 3.5% rate in 2006 and at 3% to 3.5% in 2007.

But Wall Street was unmoved, having already factored in that this scenario will probably mean one or two more hikes this year, which would take the Fed's key rate to 5%. Stocks rose Wednesday, with investors also encouraged by the price of crude oil remaining below $60 per barrel.


Dow Jones Industrial Average

rose 30 points, or 0.28%, to 11,058, staying above the psychologically important 11,000 level. The

S&P 500

rose 4.5 points, or 0.35%, to 1280. The

Nasdaq Composite

gained 14 points, or 0.6%, to 2276.

Strong earnings from


(HPQ) - Get HP Inc. Report

after the close should also be positive for the market on Thursday. H-P was rising 3.4% in after-hours trading.

The idea of a soft landing for the housing market is shared by the vast majority of economists on Wall Street -- and is therefore suspicious. Bernanke's assessment, meanwhile, is likely intended to reassure financial markets.

The soft-landing case holds that speculation, or "froth," as former Fed Chairman Alan Greenspan called it, isn't a national phenomenon, but was mostly found in regional markets, especially along the coasts.

And on Wednesday, Bernanke said he believes that mortgage rates remain low enough -- they remain benchmarked to stubbornly low long-term bond yields -- to keep overall demand for homes strong enough to cushion a cooling market.

But the fact that a "bubble zone" exists only in some areas means that it doesn't matter much if demand for homes and prices remain stable in Texas and Ohio, according to Ian Morris, chief U.S. economist at HSBC.

In an extensive report detailing regional housing trends in the U.S., Morris found that about half of the U.S. housing market is frothy, and that the "bubble zone" may be overvalued by 35%-40%.

"Our research suggests that the areas infected by the housing market's version of irrational exuberance are big," Morris wrote. Indeed, they represent 50% of the housing market in value terms. That's $6 trillion, or 50% of the U.S. GDP., and is nearly the size of the German, French and U.K. economies put together, the economist notes.

Even a perfect soft-landing scenario, in which national home prices just flatten, would imply a 35%-40% collapse in existing-home sales. Together with a drying up of mortgage equity withdrawals, this would constitute a 3% drag on GDP, according to Morris.

If this is spread out over a long period of time, then the economy could very well absorb the adjustment. But if developments, such as an unexpected tightening of lending standards on the many new types of exotic loans and mortgages that have emerged in recent years, then the recession scenario becomes likely.

The rising supply of new homes on the market might have a hard time finding new owners by then.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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