Hooray! After a month of punishment, the home building stocks got a bump Tuesday. Although the Dow Jones U.S. Home Construction ETF (ITB) only managed a 1% pop, it was a welcome change from the 15% drop in the ETF in the last 30 days. There is a concern that it took a perfect storm of great economic reports, a technical bounce off the 200-day exponential moving average and a blowout earnings announcement from industry giant, Lennar Corp. (LEN), to reverse the trend, at least temporarily. In the case of LEN, even the initial 5.5% jump after the AM earnings report had dwindled to a measly 0.69% gain by the end of trading. Frankly, the day's action smells of a "dead cat bounce."
This article presents the contrarian view that the perfect storm actually is creating investment opportunities in this sector.
The Consensus Opinion
There are legitimate reasons to write off homebuilders. The aforementioned ITB ETF has earnestly climbed from $15 to $26 in the past year before the recent reversal. That is a nice 73% annual gain, and I concede that a little give-back was overdue.
The other commonly cited reason for the recent negativity surrounding these stocks is the specter of higher interest rates which mathematically make monthly mortgage payments a bigger chunk of the household income. This reduces the pool of qualifying buyers and makes the comparison with rental expense difficult. The bursting of the real estate bubble has created a notion supported by many financial advisors that renting is a better option than buying real estate. Hence, apartment REITs have been popular investments, as mentioned in our article Discovered: The Last Undervalued Apartment REIT.
I have mostly avoided these stocks in my investing career for other negative aspects of the sector that get little attention. I am a long- term investor generally, and these stocks are destined for disaster as the economy cycles. The builders hope and pray for higher prices and then get stuck having to buy land at inflated prices just to stay operational. Eventually the economy turns, and they are stuck with debt and land to pay taxes on.
I also see a trend away from the McMansions in spacious suburbs to a preference for convenient cosmopolitan locations where the volume construction of cookie-cutter models is not possible. The suburban demand has shrunken, and those markets may get saturated quickly, leaving builders with unusable land inventory. Attractive inner-city locations will require a more custom approach ... read that as higher prices and lower margins.
I am sure that sector analysts may disagree with me about the long-term value of homebuilders, and they may be right. However, I have comfortably worked around commercial and retail real estate development for 40 years. Then I had the opportunity to directly oversee the development and construction of just 140 luxury homes in a resort during the crisis, and it was the toughest assignment of my career. There are a lot of things that can go wrong and in a volume business, bad decisions get amplified: defaulting buyers and suppliers, bad location choices, competition for labor, financing schedules and deadlines, changing government requirements just for starters.
As if all this was not bad enough, slowing global business activity, cratering emerging markets and plummeting precious metals prices result in margin calls and general investor funk that may throw the U.S. markets into an extended decline.
The Contrarian Opinion
Given the above, it is hard to think that there may be exceptional profits to be made by talking a long position in the housing sector at this time. We should remember that only a month ago these stocks were bid to new highs daily. The main difference today is the constant chatter that the reduction of Federal stimulus money will create higher interest rates and that will immediately kill the housing rebound. In my SA article in March 2012, An Old School Look At The Zero Interest Rate, I proposed that keeping the interest rates low by decree was only preventing many buyers from entering the housing market. After all, when you know the rates will still be low in two years, why not wait for a better bargain. Now that buyers are sensing the reality that waiting will only make the payments higher, we may see some pent up urgency to buy.
Natalie Trunow, Senior Vice President and Chief Investment Officer at Calvert Investments agrees about the effect of rising interest rates:
"Overall, of course, it is more taxing on the economy, because money becomes more expensive to borrowers. However, it could actually trigger a positive impact on the housing market, because to the extent that U.S. mortgage rates increase gradually, that could prompt real estate buyers to step in sooner than later, which is likely to push housing prices up. In the short term it could have a positive impact on the housing market and, through a multiplier effect, the overall economy."
Another misconception is that new home sales are topping out. The latest figures indicate the sales pace is about two-thirds of the actual pace during a normal robust economy. In the conference call the Lennar CEO gave insight into the fundamental picture for housing:
"Against the backdrop of recent investor concerns over mortgage rate increases, we believe that our second quarter results together with real time feedback from our field associates continue to point towards a solid housing recovery. While that doesn't rule out "headline risk" from conflicting economic reports and interest rate increases, the fundamentals and a relative shortage of new housing stock due to the lack of construction during the downturn, has Lennar expecting a continued rebound."
The "headline risk" refers to short-term moves in the market caused by talking heads who are required to over-hype any event to get TV and radio ratings. This influences the "dumb money," and there usually is a limit to how many of these sellers can keep a market over-reaction alive; however, when they are through selling, it is usually a special buying opportunity. The Tuesday bump may indicate that these sellers are starting to thin.
This week alone we have experienced blowout reports for manufacturing, consumer confidence, and home sales and prices, far exceeding analysts' expectations. If the Federal Reserve members had not been opining in long news conferences which were promptly spun by the reporters, the real meaning of these economic reports would probably send stocks skyrocketing. They clearly indicate that the U.S. economy is finally moving out of first gear and shifting into second gear. It is not in overdrive yet and not likely to get there soon, but these reports significantly support higher probabilities for better GDP, earnings and home activity than may be currently expected by the consensus of analysts.
Although prices have risen, the current sector ETF price is actually at the bottom end of the linear regression channel, from a technical point of view, and it sits at the 200-day average, which is often a strong support level.
At the least, the sector could rebound to fill the down gap, which would represent a 10% short-term increase, which opens up option possibilities for traders.
We should mention that both gold (GLD) and the emerging market (EEM) ETFs have reached strong support levels after essentially panic selling in those stocks, so general investor sentiment may become quite bullish, quite soon. In future articles we will elaborate on those sectors.
Perhaps the most encouraging aspect of the Tuesday activity is that the interest rates on bonds were fairly stable in the face of the exceptionally positive increases in business activity indicated by the reports. This seems to say that the latest rate hikes are stabilizing and the effect of the Fed news will take a back seat to earnings season, which should be good for homebuilders. The reality is that the low rates are probably here for more than just a few months. The 7% unemployment target to trigger the "tapering" of stimulus is certainly more possible than the old 6.5% target; however, that goal may not even be possible given the productivity increases due to technology and the changing profile of the workforce, despite career politicians who are telling U.S. that they have the magic key.
The Investment Candidates
I think that the short-term situation prompted by an overreaction about the increase in interest rates warrants a short term, speculative play. PulteGroup, Inc. (PHM) is one builder that I might like as a long-term investment. It is about the only builder that has positive cash flow, according to YAHOO stats, and has a macro tailwind, the BBBs (baby boomer buyers). The BBBs bought their first homes when the mortgage rates were way above 7% and even 5% looks pretty good. Maybe they will just pay cash, and to hell with mortgages. Pulte is strong in the retiree market with its Sun City and other developments. We BBBs will be moving and spacious environs far from the workplace are just fine with us. Analyst estimates have been trending higher and PHM reports on July 22, 2013.
As much as we like PHM, we are not looking to put it into the long-term portfolio yet, but we do like an option trade to get our toes into the sector. We are betting that the PHM August 20 calls will at least double from the $1 price. That would only require about a 10% rebound to fill the down gap. The stock sits on its 200-day support line.
Another home builder that we watch is DR Horton (DHI). While we prefer PHM as a potential long-term investment, DHI is set up very similarly to PHM technically, and it will announce earnings on July 25. Earnings estimates are trending higher, and analysts give DHI more upside than PHM, expecting a target price of about $26.89 versus its current price of $ 20.91, a 30% increase. Despite the general increase in this group on Tuesday, DHI actually dropped a penny, while PHM was up nearly 4%. This tells U.S. that support may not be as strong as PHM, and DHI has penetrated the 200-day moving average. However, the upside on the DHI Aug 22 calls at $1 may be better given that it is apparently more oversold than PHM and more volatile. We might be inclined to wait for some signs of strength from DHI before pulling the trigger, such as a move above the 200-day line near $22. A less risky strategy may be pairing those calls with some DHI Aug 20 puts to catch the volatility no matter which direction.
Finally, for the true contrarians that want a long-term stock with exposure to the housing sector, we suggest Genworth Financial (GNW). GNW is actually an insurance company with a division for Mortgage Insurance. This company was spun off by GE Financial just in time for the housing crisis and subsequent disastrous mortgage insurance losses. If that is not bad enough, the company was also stuck with long-term healthcare policies that were underpriced and have been a drag on earnings.
So how has this gem managed to hit new highs during the June sell off? Probably the expectations of 40% earnings growth in 2013 with a single-digit PE, and 22% growth in 2014. This growth is attributed partly to the burn off of the MI losses, with likelihood that the rebound in the housing market will enable this division to show positive growth later this year and beyond. GNW also has gotten some rate increases for the long-term policies and is no longer selling those products. It has been disposing of non-core divisions to streamline the operations. While we may put GNW in the long-term portfolio, we think the GNW Sep 10 call is a good price under $1.50. GNW sits on its 50-day average and the fact that it has hit new highs in a very negative environment tells U.S. that it could explode to the upside with any positive sentiment shift, which may be justified by recent economic reports. If it flies up, we can put it into the portfolio by calling the option contracts, which only carry about a 60-cent premium for three months to watch the housing market and GNW develop.