Responding to the nth wave of interest rate declines since their 1981 peak, home buyers and investors have been bulling up the prices of both existing and new homes and homebuilding and lumber stocks up in excited fashion. The iShares Dow Jones U.S. Home Construction ETF (ITB) has surged over 60% in the past 12 months. It trades at an average P/E of 23 with a dividend yield of 0.5%. This is a pure play on homebuilders. A related ETF is a broader play on housing, the SPDR S&P Homebuilders ETF (XHB), has tracked with ITB with a tight correlation.
While I'm not bearish on any homebuilding stocks long-term, there are several reasons for caution right now. Here are some to consider.
1. The Federal Reserve's Open Market Committee has begun speaking openly of bubbly real estate conditions in some parts of the country. The Fed really kicked off this last real estate surge last year when it began a new program of purchasing mortgage-backed securities. This dropped the yield on mortgages almost to the yield of Treasury bonds themselves.
The risk is that the Fed can taketh away as well as giveth. The Fed is, I conjecture, likely to begin to withdraw stimulus by ceasing to treat houses and the banking system differently from any other industry. It makes sense for it to withdraw support for mortgages before withdrawing support for the fiscal deficit at large, or at least to do the two actions equally, given criticism from many of the charge that the Fed is engaging in fiscal matters by picking and choosing between which industries it is supporting. The Fed is sensitive to this criticism. Supporting general deficit spending by the Federal government is much more of a standard operating procedure in these extraordinary times, however. Houses stocks could get slammed without warning should the Fed telegraph a selective cessation of mortgage-back securities purchasing.
There is relevant precedent for this warning of mine. I recall watching CNBC one morning in the spring of 2005 when a representative from the Office of the Comptroller of the Currency came on and advised us that the OCC, which was and is a bank regulator, was concerned about unsound lending practices. I think this was in May. I recall it because I was having a fine time speculating in homebuilding stocks such as the ones discussed below, and sold them all. Don't fight the Feds! About three months later, almost every homebuilding stock had peaked or was peaking, and the national building boom peaked by early 2006.
2. A bubble mindset has indeed begun to return without much notice. This is exemplified by the WSJ's recent article, Margin Debt Hits Record High, which contains surprisingly blase language about a bubble-type activity:
Some see the increase as a sign of speculation, particularly if the borrowed money is reinvested in stocks.
But advisers say that margin debt can be a cheaper and easier way to borrow than a traditional loan, so they are recommending margin borrowing for uses like home renovation and business expansion.
Sean Sebold, president of Sebold Capital Management in Naperville, Ill., said that his clients aren't betting on markets with margin debt.
"There are too many other tools that you can use with better leverage characteristics," Sebold said. "Why leverage up an equity account when you can buy futures [contracts]? It's not terribly challenging to get leverage."
So far, so good- sort of: futures trading is not for most people. But that's not really what Mr. Sebold meant, as the article points out in its last line:
Sebold has recommended that a client use margin debt to help finance flipping houses, since the client could borrow money more quickly on margin than he could by taking out a different type of loan.
The WSJ is transmitting the message that while it's unsafe for investors to borrow against the value of their securities portfolios to buy stocks, for some reason to do so to renovate and then flip a house is fine. Huh?
In other words, Housing Bubble 2.0 is back. Two years ago, I pointed out in my blog that many prominent Internet IPOs that were overpriced IPOs on the way to the Holy Grail of a Facebook (FB) IPO represented Internet Bubble 2.0. When a bubble is reblown, it is not fresh the way it is the first time round. So it may not last as long or fly as high. Even if housing is flying higher from here, homes really are not good investments to flip as stocks can be. A house is a costly thing to own and to sell, and going on margin to do so is a truly dangerous, bubbly activity. Reading about home flipping in an article detailing a record level of margin debt makes me cautious about owning a housing stock.
3. At least so far as is being reported, economic activity is not really accelerating upward. This suggests that either the economy needs to get stronger, or a correction in the pace of housing sales and price increases is likely. So, if one is bullish on the real economy, industry groups that have not moved up as much as homebuilders may be better new money buys now.
4. Lumber prices have entered a bear market recently. This is not a great sign either for home construction or for the general stock market, as a 5-year+ chart of this commodity from FINVIZ shows:
The correlation between the 2010 and 2011 drops in ITB is clear:
5. Individual stock analysis supports the view that valuations are already at historical highs except for the 2004-5 period. I recall this period well. I was a Smith Barney client. Smith Barney employed a home products analyst who also became a homebuilding stock analyst. He pointed out that for decades, homebuilders were viewed as deeply cyclical companies, and their stocks followed a general rule. That rule was to buy them when they sold around or below book value and sell them at twice book. That rule was because they were all selling pretty much the same product, and their inventory was their product. However, the analyst opined (I think his last name was Kim), this was a new era in homebuilders. They now had improved their capital management procedures, and there were widespread limits to growth so that their land parcels were extra-valuable. Thus they should, he proclaimed, trade at price:book levels similar to that of blue chips, perhaps in the 3-5X range.
Well, he was wildly wrong, and no longer has this job.
The best times to have bought the homebuilders last decade were two-fold. Both times they were profitable and the stocks were cheap. One time was in Y2K, when the glamour stocks were of course peaking while the old industrial and insurance, homebuilding and other stocks had often stagnated or declined in the 1997-99/2000 period. In 1999 and 2000, I used to joke to my wife that if the stock market really was good at predicting the future, it was predicting that what Americans really wanted was to live in shacks surrounded by massive amounts of electronic gear. The homebuilders were cheap, cheap, cheap. In 2002 and 2003, they were up in price from Y2K but still very cheap, and their earnings were rising nicely. Yet you could buy most of them around book value. They're nowhere like that in valuation now. I'll discuss three homebuilding stocks that I have followed and owned for many years to show why I'm cautious on valuation, which I believe has discounted all the good news I can project.
First, Toll Brothers (TOL). Toll is a well-run company that caters to the upper-middle class. Its sales, earnings and backlogs are surging. Yet the latest consensus earnings estimates from Yahoo! Finance, which take into account last week's Q2 earnings release and updated sales and backlog projections, have the stock at about 45X FY 2013 earnings and about 25X FY 2014 earnings estimates (October end to the fiscal year). The stock is roughly at twice book value. It has never paid a dividend, I believe.
Why is TOL a better buy than a bank that finances home mortgages (among other activities) selling at a much lower P/E, perhaps around book value, and with a dividend kicker? Also, a bank can benefit from rising rates, whereas TOL is harmed by it.
Second, Standard Pacific (SPF). This stock has come back from a near-death experience. I have followed SPF for decades. I recall it turning into a limited partnership and then converting back to its current status as a C Corp. I have noted two things about SPF. One is that one cannot use its recent price trend as predictive of anything, and the other is that it almost always trades at or below book value at some point within a two-year period. SPF has a market cap of $2.1 B; its book value as of March 31 was $1.29 B. We all understand that many of its homes are going to sell at a bit of a premium in the current market, but the stock is now trading at about 25X current year earnings and 17X 2014 earnings. It's pricey and financially weak.
Finally, perhaps the blue chip in the homebuilding group is NVR (NVR). This is a financially very strong company with a base in the Washington, D.C. area- which is not a great positive right now, for a change. NVR has been shrinking its outstanding shares almost every year for years in a financially prudent way. It's been doing this at a premium to book, thus artificially reducing stated book value (as has IBM), so P:B is not very relevant. What is relevant, though, is that earnings estimates for NVR are actually declining. Despite that, it's still at 19X estimates for 2013 and about 14X for 2014.
I recall well that year after year, the stocks of these companies were considered both boring and risky. One could buy them below book (perhaps not NVR after its resuscitation years ago) and at very low P/E's which were well below market P/E's.
My concern is not that the housing market is going to collapse again, but that the extraordinary nature of the support given by the Fed and the Federal government as a whole means that it is impossible to know what a fair valuation of these common stocks is, since matters have to normalize at some point.
Just as I was correct in 1999 and 2000 that the craze for technology stocks at the expense of normal activities was excessive, I suspect that I am correct that sooner rather than later, the success of homebuilding and house prices in "healing" will lead the Federal government (including the Federal Reserve) to reduce its support of the industry. There is, after, a gigantic set of challenges for the government and the country, and after all, people will pay for a basic need of shelter with or without Federal subsidy. Given this belief, I anticipate that the recent break in lumber prices and recent back-up in interest rates suggest caution on housing stocks in the short run. In the intermediate term, the valuation concerns I have delineated, which are almost irrelevant in the short term, then come into play.
Thus, while I certainly respect the stock price and earnings momentum in many homebuilding stocks, there are a number of stocks and stock groups one can buy right now that also have positive earnings and earnings surprise trends but that have better valuations, and that are not receiving extraordinary support that could be diminished at any time. ITB and the specific names I have discussed are all OK with me for the long haul, but there can be no more positive surprises in support of this industry from the government and there can be a negative surprise or two. Given their historically high valuations, these stocks strike me as suitable for few investors other than skilled momentum stock traders or investors with a true long-term buy-and-hold perspective right now.