Sept. 29 (Bloomberg) -- Housing statistics were center stage this past week, and on its face the news appeared better than expected.

New home sales rose a surprising 4.1 percent in August -- May, June and July sales were revised down -- while existing home sales showed a scant 0.5 percent drop. The reports inspired comments (hope?) that housing might be stabilizing.

Before you get too excited about that prospect, consider the bloated inventory of homes for sale and compare the performance to previous housing slumps, says Joe Carson, director of global economic research at AllianceBernstein.

``Since the start of 2005, the inventory of unsold new homes has climbed 29 percent, while the stock of unsold existing homes is up a staggering 82 percent,'' Carson says. ``During the sharp, protracted housing downturn of the early 1990s, these inventories actually declined, helping to cushion prices.''

House prices will have to fall -- more than the 1.3 percent and 1.7 percent year-over-year decline in the median price of new and existing homes, respectively, in August -- in order to work off the current inventory glut. And builders will have to curtail residential construction until buyers chip away at the backlog.

Perhaps it's no coincidence that the graphs of new and existing homes for sale are the mirror image of the one of homebuilder sentiment. As inventories have risen at parabolic rates, industry sentiment has fallen off a cliff.

The National Association of Homebuilders Index, which includes sales, traffic and builder expectations of sales six months down the road, fell to a 15-year low of 30 in August, less than half its value a year earlier. The peak index reading for the cycle was 72 in June 2005.

Disconnect

For months, builder sentiment looked out of sync with the actual housing statistics. When one considers that the worst news on new home sales may not be reflected in the government data, it's easier to understand why they're so glum.

Simply put, cancellations are rising, and they aren't being captured in the aggregate statistics because of the way the survey is designed. Hence, sales are being overstated and inventories understated.

``Once a sales contract is signed, there's no way of recording the cancellation or putting the home back in inventory,'' says Dave Seiders, chief economist at the National Association of Homebuilders in Washington. ``Builders keep track of gross and net sales; we don't have a net sales number from Commerce.''

The Census Bureau, which is one of the Commerce Department's statistical agencies, counts an initial new home sale: Sales go up and the ``for sale'' inventory is reduced. If the sale is canceled, it isn't reflected in revisions to previous months. What happens? When the home is ``resold,'' statisticians ignore that transaction.

One House, One Vote

``We don't double count,'' says Steven Berman, the survey statistician for the residential branch of the Census Bureau's manufacturing and construction division.

When the cancellation rate is changing -- in either direction -- it can distort both sales and inventories.

We know from big builders that cancellation rates are rising. Seiders says the rate ``has roughly doubled over the last year'' and is ``more serious at the big companies.''

Just this week, Lennar Corp., the No. 3 U.S. homebuilder, said its cancellation rate was running at more than 30 percent. Net new orders fell 5 percent in the quarter ended Aug. 31.

Cancellation rates rose to 29 percent in the April-June quarter at D.R. Horton Inc., the second-largest homebuilder, and deteriorated further in July, according to the company. That compares with an historical average rate of 16-20 percent.

Miles to Go

And earlier this month, KB Home said net orders (an order is considered a sale) plummeted 43 percent in the three months ended Aug. 31, a rate that includes cancellations.

The effect of higher cancellations is ``to overstate the overall level of sales and understate the level of inventories,'' Carson says. The opposite is true at the bottom of the economic cycle, when sales pick up and the resold homes aren't registered as a sale or removed from the ``for sale'' pile.

What makes the current situation so worrisome is the ``unprecedented inventory overhang, encompassing new and existing markets and many of the largest metropolitan areas,'' Carson says. ``Its sheer size raises the odds that prices will fall more and longer nationwide than they did in the 1990s.''

Carson figures it will take another 15 percent decline in starts, which are already down 22 percent from the first-quarter average, to cut inventory to below the level of demand, thereby reducing the existing overhang. At the trough of the housing cycle in the first quarter of 1991, starts were down 40 percent from two years earlier.

If it turns out that reported new home sales are overstating the level of demand to any significant degree, the needed correction could be even more severe.

(Commentary. Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: September 29, 2006 00:04 EDT