- Cheap money, work-from-home, stimulus, and wage growth caused a COVID-era boom for housing-related stocks.
- However, rate hikes, a return to the office, and growing job uncertainty are causing homebuyers to put buying plans on hold this year.
- Housing stocks have retreated, but there's little to suggest headwinds are fading.
The pandemic created a perfect storm for homebuilder profits. Facing unprecedented economic risk because of COVID-related shutdowns, the Federal Reserve cut rates to 0%, resulting in bargain-basement, sub-3% mortgage rates. Meanwhile, work-from-home trends skyrocketed, leading city dwellers to flock to rural communities and second home sales to swell.
Those two trends were bolstered by fiscal stimulus designed to support workers at risk of job loss because of collapsing GDP resulting from COVID-era lockdowns. A flood of stimulus provided a necessary backstop given economic activity contracted by nearly one-third in the second quarter of 2020. However, it also increased discretionary dollars, providing fuel for rising asset prices, including stocks, cryptocurrency, and homes.
Oh, and let’s not forget that COVID led many older workers to reconsider work altogether. Many retired early, forcing employers to chase workers with higher pay and, in some cases, five and six-figure sign-on bonuses. Those thicker wallets further strengthened home sales.
Overall, because few were selling, but many were buying, housing demand substantially outstripped supply, making homebuilding exceedingly profitable.
Housing demand hits a wall
Those heady days are over.
The Federal Reserve is ratcheting rates higher to curb inflation, which is at forty-year highs. That’s taken the average 30-year mortgage rate from below 3% two years ago to above 6% today. Generally, every 1% rate increase reduces home purchasing power by roughly 10%. So far, the Fed’s hiked rates by 2.25% this year, with another 0.75% increase expected tomorrow and more increases likely in November and December. In short, home affordability is plummeting for millions of prospective buyers.
The work-from-home trend is also fading. Readily available COVID vaccines, arguably less potent strains, and a form of COVID-fatigue have led many employers to roll back at least some work-at-home policies. As a result, fewer people are competing with new home buyers.
Demand is also on the ropes because Fed rate hikes slow economic activity, resulting in fewer average hours worked, a precursor to job cuts. In addition, global growth uncertainty makes employers more cautious about paying up to fill open jobs while making workers less eager to give up COVID-era low mortgage rates on existing homes.
As a result, cancellation rates are surging, and homebuilders and sellers are finding it harder to move existing inventory. Almost 18% of homebuilder contracts were canceled in July, up from 7.5% one year ago, according to John Burns Real Estate Consulting. Moreover, new home sales were down 30% year-over-year, and inventory climbed to 10.9 months in July, the highest level since the Great Recession. That's bad news for housing stocks.
Too soon to buy housing stocks
In “Before Buying Housing Stocks, Inspect the Market's Foundation for Cracks,” Real Money Pro’s Ed Ponsi thinks the best bet is to fade any strength in the industry until signs suggest the industry can begin growing again. His advice is to be wary of analysts upgrading the industry right now. He writes:
“The homebuilding sector on Monday was upgraded by KeyBanc analyst Kenneth Zener. Names like D.R. Horton (DHI) , Lennar Corp. (LEN) , and PulteGroup (PHM) , all raised by KeyBanc to an overweight rating, jumped higher during Monday's session…The upgrade was based on valuation. According to KeyBanc, these stocks have performed so poorly that there is now more upside than downside. Year to date, DHI is down 33.2%, LEN lost 33.1%, and PHM slipped 29.6%...The timing of this upgrade seems strange, coming just ahead of a slew of important housing data…Later on Monday, the National Association of Home Builders released a survey, and the results weren't pretty. The NAHB's housing market index reached its lowest point in over two years. It marked the ninth consecutive monthly decline in home builder sentiment, which appears to be falling off a cliff [emphasis mine].”
Homebuilding stocks have been hard hit this year, but little evidence suggests that homebuilder revenue and profit have stopped declining. Profitability is expected to contract significantly next year. For example, the consensus EPS estimate for D.R. Horton is $13.76 per share in 2023, down from $17.07 in 2022 and above $11.41 in 2021.
The situation is similar for Lennar and Pulte, as each is expected to see earnings fall double-digits next year to levels that remain above 2021.
Given demand headwinds, it seems a stretch to think that homebuilder profit won’t dip below last year. If earnings continue decelerating, homebuilders may not be as “cheap” as they appear.
Back to Ponsi:
“Since this upgrade was based on valuation, consider this: All seven of the homebuilding stocks that were upgraded by KeyBanc -- Lennar, PulteGroup, D R Horton, KB Home, Meritage (MTH) , Toll Brothers (TOL) , and TopBuild Corp. (BLD) -- were priced lower in June. If valuation is a key concern, why should investors pay more for those stocks today?...The core of Zener's thesis is that historically, the housing sector falls by an average of 41% during a downturn. XHB has already fallen by 32% since reaching its all-time high in December…While that concept seems reasonable, keep in mind that the housing rally of 2020 and 2021 was anything but average. A massive, pandemic-driven shift to work-at-home, combined with rock-bottom interest rates, pushed demand forward.”
If unprecedented easy money policies and buyers' COVID-era decision-making brought forward demand, a historically average decline might not be the best proxy for picking a bottom. Consider this point, runaway housing demand because of no-doc loans ahead of the Great Recession resulted in the XHB ETF falling from $46 in 2006 to $8 in March 2009, an 82% decline. I don't expect that big of a drop this time because we're unlikely to have anywhere near the foreclosure rate, but these stocks could still go lower.
Back to Ponsi:
“This unique set of circumstances caused housing valuations to explode higher. Because of the size and nature of the real estate rally, I'm expecting a larger-than-average pullback in both housing prices and housing stocks.”
So far, home prices haven’t budged much despite recent inventory growth. In July, median and average home prices were up 8% and 18%, respectively, from one year ago, and 2% and 9%, respectively, since January. Will we not see housing prices decline this cycle? Given recent weak homebuilder sentiment and increasingly common price cuts, I'd say prices are more likely to fall than climb in the next 12 months.
The Smart Play
Stocks bottom before economic data improves, so if the tough-sledding for housing-related stocks is over, you’d assume that housing-related stocks are improving. Unfortunately, that’s not the case yet.
Ponsi observes that “Despite Monday's optimism, XHB remains in a downtrend (diagonal lines). The ETF is also trading below its 50-day (blue) and 200-day (red) moving averages.”
It’s not just homebuilders struggling technically, either. Suppliers and DIY-related stocks also remain mired in downtrends. For example, paint company Sherwin Williams (SHW) just undercut its July lows and is only slightly above its June low. Similarly, construction supplier Fastenal (FAST) is also sitting barely above its July low, as is decking company Trex (TREX) Appliance maker Whirlpool (WHR) put in a fresh 52-week low today. Home Depot (HD) is less than 5% above its June low, and it’s down 17% since mid-August.
I suppose you could try betting the worst is behind the basket by “catching the falling knife” with these companies near summertime lows, but this basket feels like it’s still got a lot to prove. So, following in the footsteps of that upgrade is a risky bet.
Instead, I’d focus on stocks and industries with fewer headwinds working against them. Remember, I selected housing-related as one of the four groups most at risk of a recession, and there’s a chance that the U.S. notched its third negative GDP quarter in Q3. If unemployment rises, then it could be a while before homebuilders are back to their winning ways. In the meantime, I’d watch from the sidelines and treat them like they were from the show-me state of Missouri.