Home may be where the heart is, but no one should fall in love with homebuilder stocks right now.
Homebuilders took a beating in January, and like just about everything else, that can be blamed on the Federal Reserve. the
SPDR S&P Home Builders
exchange-traded fund (ticker: XHB) started the year near its all-time high. But the Fed’s December meeting minutes, which were released Jan. 5, revealed a much more hawkish tone than the market had expected. The stock market fell, as did housing stocks, with the Homebuilders ETF falling more than 14% through January 21.
That a more aggressive Fed would hurt homebuilders shouldn’t come as much of a surprise. Higher fed funds rates mean higher mortgage rates, all else being equal, and that’s exactly what happened: the average 30-year mortgage rate went from 3 .11% at the end of December to 3.55%. based on Freddie Mac. And higher rates are expected to slow home sales because they will put homeownership out of reach for some potential buyers. According to
Real estate activity, however, already looked set to slow, with or without the Fed. Pending home sales have plummeted 3.8% in December from November, according to the National Association of Retailers, which blamed the decline on a lack of homes for sale. But there’s also a good chance higher prices — they were up 18.8% in November year-over-year, according to the S&P CoreLogic Case-Shiller home price indexes — will give some buyers doubts or simply pushing a new home out of their price range, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. “The NAR blames the lack of inventory, but we also cannot ignore soaring home prices which in turn deters some potential buyers,” he wrote.
Then, Fed Chairman Jerome Powell had to try to convince the financial markets of his credibility in the fight against inflation. The fed funds futures market now reflects a 66% chance of six rate hikes in 2022, up from 13% just a month ago. Four rate hikes are almost a given. And let’s be clear on one thing: crunch cycles have historically been pretty bad for housing stocks. Over the past seven bull cycles, real estate stocks have outperformed twice, managed to end higher but underperformed once and fell four times, according to UBS data.
Yes, housing inventories are already reflecting much of this pain. UBS analyst John Lovallo notes that the average homebuilder stock was trading at just seven times 2023 earnings on January 19, suggesting the market has already adjusted to the possibility of increases Fed rates and slowing home sales. Still, Lovallo argues there’s enough pent-up demand to sustain sales, which could lead to 50% multiple growth and more than offset lower earnings estimates. “Builder stocks could spring up this spring,” he wrote.
However, valuing homebuilders by their profits may not be so common anymore. Traditionally, they’ve been valued on the basis of price-to-book ratios, and BofA Securities analyst Rafe Jadrosich returned to that price-to-earnings metric in a Jan. 27 report, saying most car builders houses had “unsustainable” profit margins. “Therefore, the price investors will be willing to pay in the future will likely be based on the homebuilder’s return on equity, with stocks that have better yields earning higher valuations.
(TOL), known for its high-end homes, to underperform versus buy, citing, in part, its higher price-to-book ratio relative to its ROE and the fact that as rates go up, owners could simply choose not to go up. He cut
(LEN) to Neutral from Buy, as it trades at 1.3x P/B, a level reserved for companies with higher ROEs. He improved
Knowledge base home
(KBH) to buy at Neutral due to its low P/B relative to its ROE, and left its buy rating intact on
(DHI), citing its asset-light model and focus on entry-level housing.
“We continue to have a constructive view of the underlying drivers of demand for new homes and renovations,” he explains. “However, we see a more challenging setup for equity outperformance with rising interest rates and a potential earnings spike in 2022.”
Still, his price targets suggest further gains in all four stocks, which may prove optimistic. Part of the problem is simply the massive rally homebuilders have had over the past three years. The SPDR S&P Homebuilders ETF generated a 170% return, including reinvested dividends, from the start of 2019 to the end of 2021, easily outperforming the
SPDR S&P 500
Return of 100% of ETFs (SPY) over the same period.
Perhaps most disturbing is that DR Horton, Lennar, Toll Brothers and
(MDC) all seemed close to breaking out, according to 22V Research technical analyst John Roque, but didn’t, often leading to larger outages. Their 40-week moving averages are also starting to reverse, as is relative performance against the
index. For Roque, the conclusion is obvious.
“In short, these four stocks should be sold,” he wrote. “Short circuited if you can.”
At least until the Fed changes its mind.
Write to Ben Levisohn at [email protected]