Housing Starts: Best and Worst Years

Think 2006 has been rough for housing starts? It would have to get a lot worse before things are as bad as they were in 1991

Last week's news out of the U.S. Census Bureau seemed anything but positive—housing starts, a vital indicator of the state of the economy, slipped to a six-year low in October. The stock market dipped on the news, and economists handed in their gloomy predictions: This was the beginning of a long overdue correction that could continue well into 2007.

History, however, demonstrates that times have been worse. Total starts of construction of privately owned homes dropped to a seasonally adjusted annual rate of 1.486 million in October, 2006, down 14.6% from the revised September rate of 1.74 million. As bad as that sounds, it was nowhere near the levels of the worst months for housing starts in the past 47 years. The historical monthly median—based on data dating back to 1959—is 1.529 million, just 2.8% higher than the most recent number.

Moreover, the past indicates that this downturn in home construction is, for lack of a better word, constructive. "It's inevitable and good," says David Seiders, chief economist of the National Association of Home Builders. "It would have been better not to have the binge, but we did, and now [homebuilders] are doing exactly what they should be doing."

Post-Katrina Uptick

The "binge" in home construction peaked in 2005, a year known best for Hurricane Katrina, rising energy prices, the death of Pope John Paul II, and not for being the second-best year for housing starts. Katrina, of course, had no impact on housing starts, while post-hurricane rebuilding efforts had a slight positive effect on construction numbers, Seiders notes.

Only 1972, the best year on record for housing starts, beats last year's gluttonous total. That was the year the musical Hair was on Broadway, The Godfather made moviegoers an offer they couldn't refuse, and Richard Nixon defeated Senator George McGovern in a landslide Presidential election, aided by the lowest voter turnout since 1948. Where was everybody? Protesting the Vietnam War? Watching The Price is Right (which debuted on television in '72)? Or getting the right price on their first home purchase?

The year 1972 was when the first wave of baby boomers, now done with college and starting to raise families, set out looking for their first home, notes Steve Berman, section chief of the residential branch of the Census Bureau's manufacturing and construction division. Over 1 million apartments were being built, Berman says, adding to the year's housing starts total of 2.3566 million.

'90s Flashback

Trends like these, however, are only one part of the story."Housing is still recognized as the most sensitive part of the U.S. economy [to interest rates]," says Seiders. The fed funds rate slipped below 4% in 1972 (after hitting nearly 9% in 1970). It so happens that the Dow Jones industrial average closed above 1,000 for the first time in November, 1972. The years 2003 and 2004, the seventh- and sixth-best years for housing starts, respectively, saw rates drop to less than 2%.

The year 1991 wins the undesirable title of worst year for total housing starts, which tumbled to 1.0139 million. January was the worst month of the year—and of all time—with a seasonally adjusted annual rate of just 798,000. Short-term catalyst: the Gulf War, which began in January after Congress authorized the use of military force to liberate Kuwait. The shock of Operation Desert Storm drove housing numbers down to their cyclical bottom, but they would have eventually gotten there anyway. The fed funds rate was set above 8%, and the U.S. was in the middle of the late-1980s recession, a period between 1987 and 1992 when the collapse of junk bonds and a massive stock crash (the Dow lost 25% on Black Monday in October, 1987) led to an economic slump in much of the Western world.

Another recession in the early 1980s was signaled by falling housing starts in 1982 and 1981, the second- and third-worst years on record, respectively.

Interest rates hit an all-time high at this time, approaching 20%, as the Fed tightened monetary policy to control the stagflation that characterized the previous decade. Newly elected President Ronald Reagan supported the Fed's decision, which successfully reduced inflation but thrust the economy into the worst downturn since the 1930s. Reagan, meanwhile, made the largest income-tax cut in American history, and increased defense spending. The unemployment rate increased to 10.8% in 1982, from 7.5% in 1981.

Big Mac Attack

But by mid-1984—the 10th-best year for housing starts on record—unemployment was down to early 1981 levels, and it continued to decrease for the next five years. Reagan defeated Walter Mondale in the 1984 Presidential election with nearly 60% of the popular vote. Also that year, Apple Computer (AAPL) launched the Macintosh with a Super Bowl television commercial called "1984," inspired by the George Orwell novel.

Did people start building 1.7495 millions homes that year to have places to keep their new Macs? Not likely. "You're talking about major up and down cycles," says the NAHB's Seiders.

The current cycle in housing starts is apt to mimic these historical phases, bottoming out sometime in 2007. As always, what happens next depends on the Fed's next move—cutting interest rates in the first quarter of 2007 would help, but only slightly.

Lipsticked Pig

"What's driving housing down today is not so much the level of interest rates but the tremendous increase in the price of housing relative to income," says Paul Kasriel, director of economic research at the Northern Trust in Chicago. The housing affordability index put out by the National Association of Realtors is the lowest it has been since the third quarter of 1986, he notes.

There have been seven housing cycles prior to the current cycle, in the time period between 1959 and the present, and the average peak-to-trough decline of these seven cycles is 47.3%, according Kasriel's research. In the current cycle, housing starts have declined 34% from their peak in February, 2005, to October, 2006, levels. If the peak-to-trough decline in the current cycle were to match the seven-cycle average decline of 47.3%, the annualized pace would need to bottom out at 1.166 million units.

"I think we're going to at least see an average cycle in terms of starts, and housing is going to have a significant ripple affect on the rest of the economy, slowing down employment growth and consumer spending," Kasriel says. "Everybody tries to put lipstick on this pig, but it's a pig."

Sounds like ominous news, but apparently, we've heard it before.

Click here to see the years with the best and worst housing starts since 1959.