The fourth quarter is going to be a very interesting test to see how well the economy holds up during the housing downturn.

The fourth quarter is going to be a very interesting test to see how well the economy holds up during the housing downturn. Based on our conversations with builders and trades from all over the country, construction is likely to slow much more than usual in the fourth quarter because of excess inventory (most communities have enough standing or under-construction inventory to satisfy the current sales pace) and cash flow (generating cash flow and reducing debt are what most builders need to focus on the most).

Residential investment has fallen back to normal levels and we are highly confident it will fall below the norm this quarter. Let’s continue to hope that government, health care and technology businesses continue to thrive so economic growth continues.

Our grading system of the economy and the housing market is a “bell curve” model, with statistics at an all-time high receiving an “A,” statistics near the long-term average receiving a “C,” and the worst times ever receiving an “F.” In this grading system, it is OK to be a “C” student.

Here is our current report card:

Economic Growth: C

The economy weakened a bit in September, with the still-solid GDP estimate revised downward and continued slowing in the labor markets. Employment data was revised upward for the month of August, which had previously reported a year-over-year loss, though that segment of the economy continues to weaken. Income growth is slowing, and the federal deficit continues to increase. On a positive note, both productivity and retail sales improved this month.

Leading Indicators: C-

Most leading indicators performed worse in August, though the stock market continued to show strong performance. Residential investment as a percentage of GDP is declining, and a declining Purchasing Manager Index indicates that expansion in the manufacturing sector is slowing. The price of crude oil reached its highest level since 1981, after adjusting for inflation. Home builder stocks continue to suffer, as the S&P Super Homebuilding Index fell again in August to its lowest value since March 2003, equating to a 52 percent decline year-to-date. The yield curve widened to its largest spread in two-and-a-half years, reaching 62 basis points at September month-end.

Mortgage Rates: B

Both adjustable and fixed mortgage rates declined in September, and the spread between the two narrowed. The 30-year fixed mortgage rate ended the month at 6.42 percent, while the one-year adjustable rate stood at 5.6 percent. As reported by the Mortgage Bankers Association, the percentage of mortgage loan applications with an adjustable interest rate plunged to just 12 percent in September. The subprime credit market continues to worsen, as evidenced by the still-declining ABX 06-2 BBB- series, which has fallen roughly 66 percent year-to-date.

Consumer Behavior: C+

Consumer confidence in September fell below 100 for the first time in nearly two years, due to consumer concerns about the business climate and a less-favorable job market. Consumer sentiment was flat, while consumer comfort improved only slightly. We expect to see continued declining consumer confidence as the employment sector continues to weaken, as this indicator is highly skewed toward feelings of job security.

Existing-Home Market: D+

Conditions in the existing-home market remain weak, with indications that they will continue to deteriorate. Annualized home sales fell to 5.5 million in August, which is a new five-year low. The existing-home sales volume has declined 13 percent in the last year, following a 12 percent decline in the prior 12 months. The National Association of Realtors’ Pending Home Sales Index, which measures contract activity and is a good leading indicator for home sales, reached a new low in August, indicating that sales numbers are likely to remain low for the near future. The level of existing-home inventory continues to rise, reaching 10 months of supply on the market, which is the highest level since 1988.

New-Home Market: D-

The new-home market was weaker in August, as evidenced by a record-tying low in builder confidence: the National Association of Home Builder’s Housing Market Index fell to 20, which is equal to the low reached in January 1991. The new-home sales volume fell to an annual rate of 795,000, and the supply of unsold new homes in all stages rose to 8.2 months. We expect to see the new-home statistics continue to worsen as the impact of the recent tightening is accounted for in the future months’ data.

Housing Supply: D+

Housing supply continues to contract. Permit activity fell to a 1.31 million-unit annual rate in August, including a decline to 926,000 single-family permits. Starts continue to decline as well, falling to 1.33 million in the last 12 months, and single-family starts are now below 1 million for the first time since March 1995. Housing completions decreased again this month to 1.5 million and have dropped 19 percent year-over-year.

John Burns is the founder of Real Estate Consulting in Irvine, Calif., which monitors changes in real estate market conditions and provides consulting services, including strategic planning, market research and financial analysis. He can be reached at jbrec@realestateconsulting.com.

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