Existing home sales fell by 0.6% (seasonally adjusted annual rate) to 5.02 million from a 5.05 million rate in January. This was just 7.0% above the extremely depressed rate of a year ago. However, it was slightly better than the consensus expectations of a 5.00 million rate.

Existing home sales shot up in the fall as people thought that the “first-time buyer” tax credit was going to expire on them. The credit was not only extended at the last minute, but it was expanded to non-first-time buyers as well. To qualify for the extended tax credit, people must be under contract by the end of April and close by the end of June.

As the first graph below (from http://www.calculatedriskblog.com/) shows, the extended tax credit has not packed nearly as much punch as the first one did. It will be extremely interesting to see if there is another flurry of used home buying as the credit nears expiration in a few months. However, looking at the graph, it appears to me that a rate of around 5.0 million is not particularly unhealthy from a longer-term point of view.

Yes, it is well below the bubble peaks, but it is also around where we were from late 1998 to the end of 2001. In any case, used home sales really only affect overall economic activity indirectly. When people move into a new (for them) house, they tend to redecorate it to suit their tastes. That can stimulate sales of paint, which is nice for the likes of RPM International (RPM) and Sherwin-Williams (SHW) and of furniture, helping out firms like Ethan Allen (ETH).

However, the amount of economic activity generated by a used home sale is insignificant relative to the effect that a new home sale has on the overall economy (the new home sales data is due out tomorrow morning). The biggest economic beneficiaries of higher used home sales are used home dealers, aka realtors, just as the biggest beneficiaries of higher used car sales are used car dealers. (Have you ever noticed that nobody really cares about the level of used car sales in the country, but lots of ink is spilled each month when the new car sales numbers come out? There is a good reason for that, and the same principal holds with houses.)

Of much more concern was that inventories shot up by 9.5% to 3.59 million, which is just 5.5% below year-ago levels. This put the months of supply at 8.6, up from 7.8 months in January (both falling sales levels and increasing inventories contributed to the rise).

The second graph (also from http://www.calculatedriskblog.com/) shows the months of supply had fallen dramatically as we had the spike in sales due to the tax credit, but have now risen sharply for the last three months in a row. This is bad news.

For the first half of the decade, the months of supply generally hovered between 4 and 5 months, which is probably a bit on the low side. However, the decisive break through 6 months supply in mid-2006 was one of the best warning signs that the housing bubble was going to burst. Yes, we are well below the peak levels of around 11 months reached in mid-2008, but 8.6 months is still far too high, and things are very much headed in the wrong direction.

It is not clear just how much of the recent rise is from “shadow inventory” moving into the light. The high level of inventories are going to mean that housing prices are not going to be able to stage much of a recovery. Year over year, the price of a median single-family home was down 2.1% to $164,300, while the median condo price fell 0.2% to 170,200.

Existing Home Sale Price Levels

While the level of existing home sales activity is relatively unimportant (or at least relative to the amount of attention it gets), the price level is very important (even though the median price is not the best indicator of it, since mix issues can greatly affect it. The Case-Schiller index, which is due out next week, is a better measure).

For the vast majority of Americans, the equity in their houses is, or at least was, their largest store of wealth. While the total value of residential equity wealth is roughly the same size as the value of the stock market, stock market wealth is vastly more concentrated. After all, nobody has $1 billion worth of personal wealth in their house or houses, while Forbes publishes a list each year of those that have billions in stock market wealth (often concentrated in a single stock, such as the case of Warren Buffett and Berkshire Hathaway [BRK.A], [BRK.B]).

With almost one out of four houses with mortgages now “underwater,” the decline in housing wealth in the country over the last few years has been massive.

This is despite extraordinary measures being taken by the government to prop up housing prices. Those measures include the aforementioned tax credit (if you subsidize a transaction, some of the benefit goes to the buyer, and some goes to the seller in the form of higher prices) and the Fed’s nearly completed program of buying up $1.25 trillion in residential mortgage-backed securities (paper backed by Fannie Mae [FNM] and Freddie Mac [FRE], as well as by Ginnie Mae).

Each time housing prices go down, more people slip underwater on their mortgages; when prices rise, more people are able to catch a breath. Theoretically, if housing prices are above the level of the mortgage, foreclosures should be zero, since the homeowner would always have the option of selling the house and retaining at least some of their equity (but not have the house) rather than have the house foreclosed upon, in which case they have neither the house, nor the equity.

When people are deeply underwater, say by more than 20%, it becomes worth their while to “strategically default.” That is, simply stop paying their mortgage and wait for the sheriff to show up at the door, regardless if they have the cash flow available to pay the mortgage.

Of course, if they are both underwater, and lack the cash flow to pay the mortgage (if say, they are out of work), then the combination leads to extremely high foreclosure rates. Those people who are either very far behind on their mortgages or have houses that are already in the process of foreclosure are where the shadow inventory comes from).

Relative to rents, housing prices are back close to normal from the extremely overvalued levels of a few years ago, but are certainly not “cheap,” and are actually still slightly above the long-term average. So with increasing inventories on the market, there is still room for housing prices to fall, but I would not expect another collapse like the one we have seen over the last three years or so.

Regionally, the Midwest fared the best with a 2.8% monthly increase, closely followed by the Northeast with a 2.4% rise.  Year over year, though, the Northeast is in the best shape, with sales up 12.0%, with the Midwest following, up 8.8%.

The West suffered the biggest decline on the month, with sales falling 4.7% and up just 3.4% year over year. In the South, the largest of the four regions, sales fell 1.1% on the month but are up 6.9% from a year ago.

As far as prices are concerned, only the Northeast has higher median prices than a year ago, up 7.5%, even though it was already the most expensive region of the country for housing, with a current median price of $254,700. The worst year-over-year decline is in the second most expensive housing region, the West, where the median home price is down 9.8% year over year to $207,900.

In the Midwest, the cheapest region with a current median price of $128,000, prices are down 2.0% year over year. In the South, prices are down 4.2% year over year to $139,600.

Single family sales fell 1.4% on the month but are up 4.3% year over year. The much smaller condo market fared much better, with a 4.8% increase on the month and up 30.3% from a year ago.

Since the level of housing sales was roughly in line with expectations, and because of the modest economic impact that used home sales have, I don’t think that this report will be a major factor in the market. However, the rise in inventories is a serious concern since it lays the groundwork for another (but smaller) drop in existing home prices.

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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