Popping the housing bubble myth and how to trade it: the strong housing market has kept many...

One way to trade successfully is to know when to fade what's considered common knowledge. Take, for example, the currently in-vogue notion that there is a speculative bubble in the price of housing. While home prices are somewhat elevated, the case for a sudden price decline is weak. The elements

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The persistent focus on the possibility of a housing bubble is rooted in several factors, particularly the worry that the housing market has replaced the stock market as a form of speculative investing. Second, mortgage debt has grown rapidly over the past few years, particularly relative to home values. Third, home values have increased at a fast pace relative to national income, an unsustainable trend in the long-run.

Despite these worries, there are seven basic reasons why it is irrational to think that the housing market is a bubble: inventories, the nature of real estate, competition, interest rates, the pace of price increases, urban sprawl and demographics.

SEVEN SIGNS

Here's the logic behind seven solid reasons why the notion of a price bubble in the housing market doesn't hold water.

1. Inventories. One of the most necessary elements of a bubble is an excess of supply. In the housing market, there is virtually no excess at all. Burned by the real estate bubble of the late 1980s and motivated by the need to cut costs, home builders no longer engage in speculative building to the degree they once did, and instead build homes largely to meet demand.

Indeed, the supply of new homes relative to sales now stands at a nearly 30-year low of 4.3 months (the 30-year low was set in November 1998 at 3.5 months). The current inventory-to-sales ratio stands in stark contrast to the peak of 9.4 months set during the last bubble in January 1991.

With the inventory of unsold home at extremely low levels, very few homes would have to be liquidated in the event demand were to weaken. This means fewer fire sales to bring down home prices.

2. Selling homes isn't like selling stocks. People don't trade their homes like they do stocks. The process of selling a home and the motivation for selling is so immensely different from that of stocks that widespread selling of homes would seem implausible, so any sudden increase in the amount of supply is unlikely to occur. The stock market is much different, of course, because sudden surges in selling activity do occur, causing sharp price declines.

3. Competition for capital is modest and risk-aversion remains relatively high. With returns on competing assets quite modest over the past few years, the housing market provides an attractive alternative for household savings. Moreover, the bursting of the financial bubble and September 11 have increased the equity risk premium, and this has led investors to channel money away from stocks toward other assets such as bonds and the real economy--the housing market, for example.

4. The secular downtrend in rates is more entrenched. One of the factors that hurt the housing market in the late 1980s were high mortgage rates. Indeed, the average 30-year mortgage rate stood at more than 11% compared to less than 6% today. With inflation expectations having moved sharply lower since the last housing bubble, a sharp jump in mortgage rates is unlikely. Moreover, continued growth of government agencies such as Fannie Mae and Freddie Mac will help to support the funding needs of the housing market compared to past years, even as the Federal Reserve tightens credit.

5. The recent rise in home prices is not unusual. While home prices have been increasing at a fast pace in recent years, particularly in some U.S. regions, the price increases have not substantially deviated from the long-term trend. The price gains are measured when put in the context of the extraordinary demand seen over the past few years.

6. Urban sprawl has increased as a result of September 11. It is rational to think that there may be an extended long-term shift in housing demand toward suburban areas in response to anxieties related to September 11. The sprawl adds to the demand for single-family homes, which account for 80% of all housing starts, thus providing incremental support for home prices.

7. Demographics. Increased immigration and household formation have spurred demand for housing, creating a natural source of demand that is far removed from speculative activity and is therefore more sustainable.

BURIED UNDER DEBT

With respect to concerns over the rapid growth of mortgage debt, the bears make a compelling case based on recent data showing that household mortgage debt has increased by $2.9 trillion to $7.2 trillion through the past five years.

There are two reasons why concerns over the growth of mortgage debt are misplaced. First, the rapid growth of mortgage debt was temporarily boosted by the extraordinary mortgage refinancing boom of 2003 as many households refinanced to cash out some of the equity in their homes. Second, the debt growth that stemmed from the mortgage refinancing boom has helped to improve household balance sheets by lowering mortgage payments and by consolidating other forms of consumer debt such as credit card debt.

All these factors refute the notion of a housing bubble and are powerful forces against the likelihood of any meaningful price drop. While there is always the possibility that home prices could weaken in some areas of the country, a systemic decline is likely to be stymied by these factors.

For traders betting that a bursting of a supposed housing bubble will spell trouble for the U.S. economy and will, thus, weaken equities, strengthen Treasuries, and cause a widening of credit spreads, these traders should consider looking to other factors to cause such market movements.

As for betting on continued vigor in the housing market, traders can expect continued strength in the commodities that benefit from such strength, including copper and lumber, for example. There are roughly 440 pounds of copper used in the construction of every new single-family home. This illustrates the importance of housing to this commodity.

RELATED ARTICLE: NOW, THAT'S A BULL MARKET

One of the most solid investments since the early 1990s has been residential housing.

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Source: Bloomberg, Miller Tabak

RELATED ARTICLE: What if we're wrong?

While the evidence suggests that there is no housing bubble to pop, it's better to be prepared. If a sudden and deep weakening of the housing market ensues, futures traders might consider several strategies to take advantage of the slide.

The basic premise for these strategies is a decline in home prices would likely hurt consumer spending and provide all the reason the Federal Reserve would need to shift back to an expansionary monetary policy. Weakening in consumer spending seems likely because the housing market has been a key source of capital to the household sector in recent years.

Fed-funds futures are an obvious candidate for betting on changes in the direction of the economy as they give you the ability to place trades that are directly tied to the Federal Reserve's decisions on interest rates. Traders could consider purchasing futures contracts in late-expiring contract months, which are the most likely to benefit from speculation that arises over the possibility of future cuts in the federal funds rate. These contracts are best for placing bets on events looking six months out, as liquidity beyond six months is sparse.

Eurodollar contracts are a far better instrument for placing trades beyond six months and the liquidity in both near- and late-expiring futures is very high, to say the least. These contracts will move in lock step with changes in the federal funds rate as well as expectations for such. Keep in mind, however, that eurodollar rates trade at a spread above the federal funds rate, so you also are trading on the spread, as well--although this is a much smaller part of the profit and loss equation.

One particularly attractive eurodollar strategy would be to sell near-expiring contracts vs. buying late-expiring contracts. The strategy benefits from increasing levels of speculation about the possibility of future interest rate cuts, as the back months increase faster in price than the front months, because there is more time in which rate cut scenarios could develop and thus impact the back-month contracts.

In the Treasury market, participants might consider purchases of two- and five-year T-note futures, which would benefit more from a change in Fed policy than would the 10- and 30-year maturities, as the yield curve tends to steep-en on any notion of a slowdown in economic activity.

The housing market could well hold the key to the outlook for consumer spending and, hence, the economy. Consumers have become more dependent upon their homes as a source of money and for capital gains. Should the sector be undermined, it could be a signal for traders to implement strategies that benefit from a change in the course of monetary policy.

With inflation expectations having moved sharply lower since the last housing bubble, a sharp jump in mortgage rates is unlikely. AC

Anthony Crescenzi is a bond market strategist at Miller Tabak & Co. and author of the recently published book, The Strategic Bond Investor. E-mail: acrescenzi@millertabak.com.