Existing Home Sales fell 5.1% to an annual rate of 5.37 million in June from a rate of 5.66 million in May, although that was 9.8% above the 4.89 million annual rate a year ago. The rate was, however, well above the 5.09 million rate that was expected by the consensus of economists.

However, existing home sales are recorded when the sale is closed. While to get the homebuyer tax credit of up to $8,000 the contract had to be signed by the end of April, people had until the end of June to close on the sale. Thus, the June number is artificially inflated and is likely to fall sharply in July. Inventories of existing homes rose by 2.5% to 3.99 million.

That, combined with the lower sales rate, puts the months of supply at 8.9 months, up from 8.3 months in May. It is very likely that the months of supply will rise back into the double digits next month. A healthy housing market has under 6 months of inventory available.

As the first graph below (from http://www.calculatedriskblog.com/) shows, during the housing bubble the months of supply generally stayed between four and five months. A double-digit months of supply is almost sure to lead to renewed downward pressure on the price of existing homes.

As that happens, more and more people will become underwater on their houses, owning more on the mortgage than the house is worth. If the value of a house is more than the amount of the mortgage, theoretically the foreclosure rate should be zero.

After all, regardless of how bad the homeowner’s cash flow situation, if the house is worth more than the mortgage, it is better to sell the house and get something rather than lose the house to foreclosure and get nothing. If a house goes too far underwater, the economically rational thing for a homeowner to do is to simply stop paying the mortgage and live rent- and mortgage-payment free until the sheriff shows up at the door.

There are, of course, other non-economic factors (kids not wanting to be forced to change schools, ties to the neighborhood, etc.) that go into making that decision. Those sorts of considerations are generally not present in commercial real estate or for investors who buy houses, and thus they have a much greater propensity to ruthlessly default. Also, the rich are far more likely to default on houses with million dollar mortgages than people from the wrong side of the tracks are to default on $100,000 mortgages if they slip below the waves are become underwater on the mortgages. The rich are more likely to see a house as a losing investment than as a “home” to live in.

Given the last minute rush to get in under the wire for the tax credit, I’m not really sure why the consensus was looking for such a big drop this month. The big decline should happen next month. The tax credit has not been very effective in raising the total demand for housing, but it has been effective in shifting the timing of when the sales take place.

The credit was widely expected to expire at the end of November, and as the second graph shows, that caused a big rush to buy houses at that time, only to be followed by a hangover afterwards. The credit was unexpectedly extended and actually expanded to include not just new home buyers, but existing buyers as well, and we got a second, smaller bounce in April and May. It is sort of a surprise that the bounce did not last through June. The initial bounce in sales is also the reason the months of supply fell sharply last November.

It is an open question if the July sales rate will fall below the cycle lows we saw for new home sales in late 2008/early 2009. The fact that mortgage rates are at the lowest rate on record (since 1971) at 4.74% on average in June, down from 4.89% in May and 5.42% a year ago, should help keep at least some sales going. Rates continue to fall and are currently at 4.56%.

On the other hand, why would someone buy a house in May instead of in April (and close in July rather than June) and miss an $8,000 gift from Uncle Sam? Even with very low rates, sales are likely to be very ugly next month.

Economic theory tells us that if a transaction is subsidized, the subsidy will be split between the buyer and the seller. The seller’s portion of the subsidy shows up in a higher selling price, even if the direct benefit goes to the buyer. As a result, it should not be a surprise that the median price of an existing home rose 1.3% from a year ago to $184,200.

However, the median price can be affected by the mix of houses being sold, and thus is not the best measure of home prices. The gold standard are repeat sales indexed like the Case Schiller index (due out next Tuesday, but for May data).

Sales by Region

The regional data suggests that the mix may well have contributed to the increase in the median price. Sales in the Northeast were up 7.9% for the month and up 17.1% year over year. The Northeast is the most expensive area of the country when it comes to housing, with a median price of $244,300, although that is down 1.2% from a year ago.

Partially offsetting that was the West, which is the second most expensive region with a median price of 221,000, up 1.5% from a year ago. Existing home sales plunged 9.3% out West from May, although they are still up 0.9% from a year ago.

Sales in the inexpensive regions of the country fell. Sales in the Midwest where the median price is $155,900 fell 7.5% for the month but are up 11.8% from a year ago. In the South, which is by far the largest region, the median price is $163,600, unchanged from a year ago. Dixie existing home sales fell 6.5% for the month but are 11.0% higher than a year ago.

Existing vs. New Home Sales

Existing home sales, however, only indirectly affect economic activity. When people move into a “new for them” house they will tend to redecorate. That can help generate sales of paint, which helps companies like PPG (PPG) and Sherwin Williams (SHW).

That, however, pales in comparison to the amount of economic activity generated by building and selling a new home (labor, lumber, drywall, plumbing fixtures, etc.). That means more business for firms like Weyerhaeuser (WY), Masco (MAS) and several divisions of Berkshire Hathaway (BRK.B).

New home construction provides relatively high paying jobs to those without high levels of formal education. Those are the people who are most in need of jobs. In June, the unemployment rate for high school dropouts was 14.1%, and was 10.8 for those with just a high school diploma. The unemployment rate for those with a Bachelor’s Degree or higher was 4.4%.

The tax credit mostly served to shift sales that would have otherwise occurred by a few months. As such, they did very little to actually stimulate the economy. Extending the credit to move-up buyers made the program even less effective, since it results in no net reduction of the existing inventory. Even with first-time buyers it mostly served to move people from renting to owning, and resulted in a higher vacancy rate for apartments. Restricting the credit to new homes only would have resulted in FAR more bang for the buck.

Historically, it is residential investment — aka the building of new homes — that kick-starts the economy when it is in a recession. However, that would have resulted in building of new homes. That’s great for current economic activity, but not good when the country is already oversupplied with houses.

Ultimately, it is the massive oversupply of houses that is a key reason that the current economic recovery is so lackluster and likely to remain so. On the other hand (OK, I’m one of those economists who is like an incarnation of the Hindu God Shiva, with a lot more than two hands — but isn’t every economist?), building more houses would stimulate more employment. Higher employment rates will lead to higher rates of household formation. In other words, if Junior has a job, he can get out of Mom and Dad’s basement and into a place of his own, thus stimulating demand for housing.

The Construction industry has been particularly hard-hit in this downturn, accounting for one quarter of all the jobs lost. If one considers all the non-construction jobs tied to new housing (factory workers making construction materials, lumberjacks, etc.) the percentage is probably much higher.

Months of Supply

Given the dynamics between home prices and people becoming underwater on their mortgages and foreclosures, the most important part of used home sales is how it affects the months of supply and thus they likely direction that house prices will go. For most Americans, the bulk of their wealth is (or at least was) tied up in the equity in their houses. The total amount of wealth in home equity is roughly the same size as the total amount of wealth in the stock market.

However, stock market wealth is far more concentrated among the ultra wealthy. After all, Bill Gates might have built himself a very large and expensive house, but it is just a rounding error when it comes to his total wealth. The same is not true for the average homeowner.

The wealth effect from housing wealth is generally estimated to be between 5% and 7%. In other words, if the value of your house goes up (or down) by $1,000, you will on average spend between $50 and $70 more (less) per year than you otherwise would have. The massive decline in housing wealth since the peak of the bubble is thus one of the key reasons why consumer spending has been so lackluster (high unemployment and very low wage growth also play a big role there, as well).

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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