The Downside of the Building Cycle

What is the last shoe to fall in a housing downturn? According to Stephen Roach, that would be construction activity. Once we see its demise, we should expect the "downside of the building cycle could be both deep and prolonged."

Abelson has all the details:

WITH ALL ITS FOIBLES and an incurable tendency to occasionally go berserk, the market has an enviable record as an economic forecaster. No surprise, really, for it can be a pretty good diviner of the economy’s currents and even better at spotting its incipient tides. On this score, it certainly boasts some palpable advantages over economists. For one thing, it doesn’t talk gibberish. For another, you don’t have to take it to lunch to find out what it thinks.

At the end of the day, of course, what’s happening to the economy and what’s likely to happen to it determine what the market does or fails to do. But as anyone knows who has dipped as much as a small toe in it, the blamed thing can be quite quixotic, responding to emotion and kindred unreasonable influences rather than solid data or definable prospects.

Which, in part, anyway, we suspect, accounts for its rather doughty performance of late in the face of daunting fundamentals, most particularly an already wobbling economy slated to get who knows how much worse as housing collapses, as it surely will, like a house of cards. On this score, as the latest dispatches from the home front make clear, the drop in demand, the rise in unsold houses and the beginning of what we believe will be a dramatic fall in prices, all are coming sooner and with greater velocity than even growling old bears like us expected.

What’s more, as Morgan Stanley’s Steve Roach points out in an especially perceptive commentary that popped up on our screen Friday, "construction activity is the last shoe to fall in a housing downturn. Due to sunk fixed costs of land and property acquisition by developers, homebuilding typically continues into the inventory overhang phase of the cycle. Such is the case today — with residential construction activity still holding at relatively high levels…."

However, Steve sternly warns, "once this last gasp of project completions runs its course, the construction downturn should gather force. Given the magnitude of the current inventory overhang, the downside of the building cycle could be both deep and prolonged…."

For quite a spell now, we’ve been preaching a similar sermon. The logic seems inescapable: The greatest housing boom this fair land has ever seen is over and is due to be followed by one big bust. All by itself, housing has been a mighty prop to the economy, and its crumbling can’t help but have widespread and unmitigatedly ugly repercussions.

Forgive us for repeating this gloomy screed. But we think it’s critical that nice, smart folks like you not be sucked in by recent signs of life in the stock market. What has buoyed the market have been sentiment — investors have grown increasingly wary — and, relatedly, a towering short interest. On the latter score, shorts may be wrong but they’re no dopes. They’re the quintessential short-term traders and they tend to rush for cover when the trend runs against them. And they’ve been doing some of that in recent sessions.

The sentiment figures speak for themselves. Investors Intelligence surveys show a consistently thin plurality of bulls over bears — the difference was a scant 3% in one recent canvass. In like vein, the American Association of Individual Investors’ latest poll of its members, who tend to be small plungers and nervous, showed 39.4% bullish and 37.4% bearish. While soundings of pros by the Consensus Index and Market Vane exhibit similarly subdued enthusiasm for stocks. And ISI’s survey of hedge funds showed those flighty birds pulling in their wings a bit, trimming their net exposure to equities to about 50%.

None of these contrary indicators are at levels where you could go out and buy the market blind. But they all express sufficient caution to explain the action of the market and the possibility, if not likelihood, of a further rise. However, these are strictly ephemera and most emphatically hardly the stuff to shake our conviction that a serious bear market is out there waiting to happen.

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