Advice for 2007: Avoid housing stocks

By Robert Walberg

One of the key questions in the new year for Wall Street, investors and the entire economy is whether the housing sector will begin to recover.

My friend and fellow MSN Money contributor Jon Markman recently argued that the housing sector was poised to extend its recovery rally off last summer's lows. He cited low -- and falling -- interest rates, favorable demographics and overly negative sentiment as reasons to continue buying.

I couldn't disagree more strongly. Here's why:

First, interest rates have acted as a tailwind for the sector for much of the past 20 years, with mortgage rates falling from the midteens down to about 5%, their lowest level in nearly 40 years. Unfortunately, rates are much more likely to be a headwind to housing in the future. Anyone who has considered buying a house over the past six months knows that rates have already come well off their lows. Mortgage rates might be off their summer peaks, but they aren't going to fall far before resuming their ascent.

Why rates are headed up

Even if the economy slows, rates won't fall far because of two disturbing trends. One, the federal budget deficit continues to grow at an alarming pace. In less than six years we've moved from a surplus to a deficit of nearly $300 billion. The deficit will explode as the baby-boom generation begins to retire and entitlement spending grows ever higher. The government will need to float more paper to pay the bills, and the only way to continue attracting foreign investment will be to offer ever-higher interest rates. Corporate borrowers will also need to raise rates in order to remain competitive with government paper.

The other main culprit preventing rates from falling much further is the soft dollar. A relatively high current-account deficit and the deteriorating U.S. budget picture continue to weigh on the dollar. In order to keep the greenback from falling too far, thus creating a crisis of its own, the Fed will need to keep upward pressure on rates. Doing so without significantly dampening economic growth will be a tough balancing act.

As interest rates climb, pressure on the housing sector will grow. First, demand will slow. Higher mortgage rates make it more difficult to buy that bigger house. We've already seen the supply of homes on the market rise to levels not seen in decades. Population growth will solve the inventory-overhang problem only if rates remain affordable. Otherwise, the high cost of buying will result in a steady, years-long decline in demand. Considering that home builders recently announced that they plan to continue construction at a rapid pace, that spells trouble.

Higher rates will also translate into more foreclosures, as consumers who used monthly adjustable-rate or interest-only mortgages to buy bigger houses than they could really afford are squeezed to the breaking point. The foreclosure rate has been rising steadily over the past several months, and there's no reason to think that the trend will reverse soon.

Not a good investment

Another reason investors should be skeptical of predictions for a reversal in the home-building sector is that housing is no longer the appealing investment it was six, or even two, years ago. One of the big factors behind the boom in housing was the tech-related meltdown in the stock market. With rates falling, investors shifted a relatively large percentage of their assets out of stocks and into housing.

Speculators, or flippers, made fast money as home prices increased at a double-digit pace. But with rates no longer falling and demand deteriorating, home prices aren't climbing. Meanwhile, the Dow Jones Industrial Average ($INDU, news, msgs) is setting all-time highs on a nearly daily basis. Money flowing out of real estate back into stocks will contribute to the slowdown in demand for home builders.

Finally, there's the very real problem of declining sales and earnings. Growth in the housing sector came to a screeching halt last year, and there's no end in sight. Earnings in the group are expected to decline by an additional 30% to 40% in 2007 -- estimates based on a stabilizing rate environment and a resolution to the inventory overhang by the second or third quarter. In other words, those eye-opening declines are still based on somewhat optimistic assumptions.

The group is down by an average of 33.8% from its highs set early last year, so some of the bad news is already priced in. However, it's important to note that the sector has also bounced off its summer lows by an average of 33.9%. The company enjoying the biggest recovery is Ryland Group (RYL, news, msgs) -- up 59.1% from its low.

Against the backdrop of low but rising interest rates, excess supply, deteriorating demand, and slowing sales and earnings growth, there's just no way to get excited about buying housing stocks, especially after rebounds of 25% to 59%. At the very least, expect housing stocks to revisit their summer 2006 lows within the first six months of this year. Unless you are experienced at shorting stocks, the best investment decision you can make in 2007 is to stay away from the housing sector.

At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this article.