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  • Housing supply is low, but it's increasing quickly.
  • Higher mortgage rates are crimping buying demand.
  • A recession could further dampen home sales, causing housing prices to fall.
  • Homebuilder stocks have rallied, but risks suggest it's time to book gains.

The best argument for buying homebuilder stocks is a housing shortage, underpinning prices, and builder profits. Indeed, available home inventory is historically low in the United States, but it's trending higher.

The existing home supply is currently 3.3 months, substantially lower than the over 5 months supply recorded in 2014 and 2015. However, the existing housing supply was below 2 months in early 2022, and current levels are already above pre-pandemic levels in 2019 and showing little signs of slowing.

It’s a similar story for new home inventory. It clocked in at 8.9 months in October, up significantly from a record low of 3.3 months in late 2020 when COVID-driven demand surged and pandemic restrictions limited home construction. At current levels, the supply of new homes is its highest since the Great Recession.

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Home supply likely hasn’t peaked yet

If falling economic activity increases unemployment, job loss, or, at a minimum, the threat of it, could force homeowners to sell secondary and, eventually, primary residences, regardless of whether they previously locked in low COVID-era, easy-money mortgage rates.

It’s also possible that a weakening economy drives investors to unload homes acquired over the past few years.

Investors, including private equity funds, accounted for nearly one-quarter of all home sales in 2021 and over one-fifth of sales earlier this year. In addition, they were responsible for almost 30% of home sales in high-demand real estate markets, such as California and Texas. So-called mega buyers – investors with the deepest pockets -- used to account for about 1% of sales, but that skyrocketed to 3% in 2021.

For now, those investors are sitting on gains, given median home prices were $416,000 in November, up 11% year over year, according to Realtor.com. However, that could change if prices fall to reflect rising supply and slowing housing demand, mainly due to rising mortgage rates. The Federal Reserve’s rate hikes have increased the average 30-year mortgage rate to 6.5% this year, miles above the sub-3% rates offered in 2021.

Surging mortgage rates and growing unemployment suggest home affordability will likely remain a drag on buyer demand and prices on single-family homes. If so, the loss of pricing power, alongside fewer units sold, could make it challenging for homebuilders to reward investors next year.

Real Money Pro’s Ed Ponsi writes:

“In the first quarter of 2007, U.S. housing prices were at an all-time high...The Fed was raising interest rates...We didn't know it at the time, but a multi-year recession was about to begin…The Great Recession officially began in late 2007 and lasted 18 months. Housing prices were about to experience a contraction of historic proportions…Are housing prices about to experience another historic contraction?”

This isn't the same setup, but Ponsi’s not wrong to draw a parallel between easy-money home buying in 2007 and easy-money home buying post-pandemic. 

The surge in home sales leading up to the Great Recession was fueled by subprime no-doc loans repackaged into fancy debt instruments and resold to investors as “low-risk” investments. Post-COVID, surging demand was driven by rock-bottom interest rates and record money supply sloshing about. In both cases, searching for higher returns contributed to record home prices.

It’s unlikely we’ll experience a Great Financial Crisis (GFC) style decline because leverage today isn’t nearly as bad as it was then. However, we should be mindful that a weakening economy is typically bad news for home prices and sales volume, and that's a bearish recipe for homebuilding stocks.

Investors have recently overlooked that point, though. The large regional and national home builders, such as D.R. Horton  (DHI) , Lennar  (LEN) , Toll Brothers  (TOL) , and Pulte Group  (PHM) , are up anywhere between 30% to 36% from their October lows. Additionally, the SPDR S&P Homebuilders ETF  (XHB) , a diversified collection of 36 homebuilding-related stocks, is up 18% from October’s nadir.

Back to Ponsi:

“If you have profits in the housing sector, I'd use this rally as an opportunity to exit these stocks…While the lending abuses that occurred back then haven't been repeated, the economic reality for millions of Americans remains undeniably stark. While we probably won't see a repeat of 2008, housing is likely to underperform in 2023.”

The Smart Play

Mortgage rates have dropped by about 1% in the past month as bond yields have fallen because of investors’ growing interest in owning Treasuries. The Fed’s raising interest rates have made Treasury yields for bills, notes, and bonds far more attractive this year than they were previously, especially given declining stock prices and the threat of a recession.

As a result, investors have been buying Treasuries since October, causing yields to retreat from their recent peak. For example, the yield on the 10-year note, often a benchmark for setting mortgage rates, has fallen to 3.43% from 4.2% in October.

The decline takes some of the pressure off the housing market, and given the runup in homebuilder stocks, that hasn't gone unnoticed. However, rates remain higher than last year, and home prices haven’t yet retreated substantially. Given more companies are announcing layoffs, fewer new jobs are being created, and central bank officials appear bent on GDP-busting hawkish fiscal policy, any tailwind from a reprieve in mortgage rates may be short-lived.

Therefore, if you made money in the recent run-up in housing stocks, you might want to follow Ponsi’s lead and put those profits in your pocket. At a minimum, consider using trailing stop losses to protect your gains.

You might want to look elsewhere if you haven’t owned these stocks during the recent run-up. They’ve had a big move, and stocks don’t typically go up or down in a straight line. As a result, you may want to wait and see if they pull back to support and rebound before buying.

Overall, the home building industry could benefit if unemployment stays muted. Still, personal savings are at the lowest levels since the Great Recession. Also, consumers' financial strain is increasingly evident in worsening credit card delinquency and default rates, making trafficking in homebuilding stocks too hit or miss for me.

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