Planting Portfolio Hedges Around The Housing Recovery

by: Eric Parnell, CFA

The stock market continues to enthusiastically embrace hopes for a sustained housing market recovery. Over the past two years, homebuilder stocks have more than doubled in rebounding all the way back to pre-crisis levels last seen in early 2007. This optimism has also provided a vital source of encouragement for the broader market, as the health of housing is critical in supporting overall economic growth. But while the sector has certainly seen some meaningful improvement in recent years, serious questions remain surrounding the sustainability of the housing recovery. Thus, it is reasonable to explore ways that investors can continue positioning for a housing recovery while also hedging against the potential downside if such a sustained renewal fails to materialize in the end.

Putting The Housing Recovery In Context

The improvement in housing over the last few years is undeniable. But it is important to put this revival into context.

First, while the housing market is certainly better than it was a few years ago, the levels of overall activity remain extremely soft relative to historical norms. For example, while housing starts have risen dramatically over the last two years, they were recovering from levels that were more than -2 standard deviations below the historical average and have only rebounded to levels that are still more than -1 standard deviation below the mean. And while the trend higher in housing starts certainly remains intact, some renewed signs in weakness are a bit disconcerting given that the reversal is coming at already low absolute levels.

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Housing permits have also shown encouraging signs over the last few years but also show that more work needs to be done. After bouncing from historically low levels at roughly -2 standard deviations below the historical average, the recent improvement over the past two years has only brought permits back to levels that are still roughly -1 standard deviations below the norm.

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In short, the housing market has rebounded from unprecedented lows to levels that effectively marked the absolute worst levels of every other major housing market correction over the last half century. Thus, the recovery over the two years is a good start, but we have a very long way to go in a U.S. economic growth environment that is lackluster at best.

The recent sharp rise in interest rates has added to concerns about the sustainability of the housing recovery. Most significantly, mortgage rates have risen more than a percentage point over the last few months from the low to mid 3% range to well above 4% today. While it will take several months to understand the full downside impact of this recent sharp rise in mortgage rates, it almost certainly changed the homebuying calculus for a number of prospective buyers that have been forced to step away as a result. Of course, it could also be positively argued that prospective homebuyers that were otherwise waiting to purchase a house may have been encouraged to make their move now to protect against an even further back up in mortgage rates. It will be interesting to see the net impact in the end.

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From a longer-term perspective, it is important to keep this recent increase in rates in context. Yes, mortgage rates have risen sharply in recent months, but they rose from historically low levels. It was just a couple of years ago that prospective homebuyers were celebrating the mere possibility of securing a 30-year fixed mortgage at a rate below 5%. Today, we are lamenting the fact that mortgage rates have moved back above 4%. Despite the recent rise, these remain extremely attractive borrowing rates.

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Instead, investors may be well served to focus on more qualitative issues associated with the housing recovery such as the composition of buyers supporting today's housing recovery and growing signals that speculators are once again back to flipping houses in selected markets across the country. This is important because a housing recovery is far more healthy when supported by long-term buyers who intend on owning and living in their homes instead of short-term speculators that are using cash and liquidity in an attempt to turn a quick profit on a real estate property.

With all of this being said, the bottom line is the housing market has improved. And the optimist would look at the current housing data and conclude that considerable more room for improvement exists in the coming years before we return to normal historical levels. Thus, it is worthwhile to explore the potential investment opportunities associated with such a continued recovery.

Homebuilders Running Too Hot

Homebuilder stocks (NYSEARCA:XHB) provide the most direct exposure to a potential housing recovery. This not only includes the homebuilders themselves such as Toll Brothers (NYSE:TOL), Ryland (NYSE:RYL) and Pulte (NYSE:PHM), but also those companies closely tied to the homebuilding industry such as Lowe's (NYSE:LOW), Home Depot (NYSE:HD) and Mohawk (NYSE:MHK). The stocks in this sector have collectively skyrocketed over the last two years on such hopes for a prolonged housing rebound. But with homebuilder stocks having already fully returned to pre-crisis prices from early 2007 with starts and permits still at historically depressed levels, it raises some legitimate questions as to whether homebuilder stocks may have run way too far ahead at this point given the persistent questions about whether the housing recovery is sustainable going forward. Thus, it is worthwhile to look elsewhere to determine if other sectors might offer better exposures to a potential housing recovery along with other intangible benefits including better downside risk protection.

Banks Potentially Offer Better Opportunities

Regional bank stocks (NYSEARCA:KRE) also stand to benefit considerably from a sustained housing recovery. And up until the last 18 months, the price performance of homebuilding and regional bank stocks were extremely highly correlated, as mortgage lending is a key source of business activity for many regional banks. It has only been since the start of 2012 when the stock price performance of these two sectors have deviated dramatically with homebuilding stocks surging well ahead while regional bank stocks have lagged behind. Thus, a reasonable strategy might be to consider allocating to regional bank stocks with the idea that the sector has a great deal of room to catch up to the upside. And if the housing sector falters, the regional bank stocks would presumably have less downside exposure under such a scenario all else being held equal.

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But perhaps an even better possibility exists to gain such exposure to a potential housing recovery in a more risk-controlled framework. And the financial sector (NYSEARCA:XLF) may actually rank among the best choices for several reasons.

First, the financial sector has also been highly correlated to the homebuilding sector until recently. And during the period since early 2012, financials have trailed their regional bank brethren by a considerable margin. Thus, financial stocks offer the potential for even greater upside in a catch up scenario as well as greater downside protection, ceteris paribus, if housing shows renewed weakness.

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Second, the financial sector consists of some of the largest too big to fail institutions that continue to directly benefit from the persistent and extensive generosity of the U.S. Federal Reserve whether investors agree with it or not. In short, the Fed continues to do whatever it can to make the operating environment as ideal as possible for these leading financial institutions, which provides an added tailwind of operational support going forward.

Third, the financial sector along with the regional banks is currently trading with the positive investor sentiment that the recent spike in interest rates is beneficial from a profitability standpoint. This is due to the fact that higher interest rates have the potential to result in higher earnings for banks due to increased profitability on loans, new investments and bond trading among other things. Whether higher interest rates actually have such a beneficial impact on the earnings of financial institutions remains to be seen. But the fact that this is currently the belief of the market has the potential to support higher stock prices in the near-term.

Fourth, the financial sector remains a significant underperformer relative to the broader market as measured by the S&P 500 Index (NYSEARCA:SPY) since the outbreak of the financial crisis. And it was only at the beginning of 2013 that financials finally broke out above a long-term trading channel that had been in place since late 2009. So while the broader stock market continues to reach new highs, the financial sector has been languishing until recently and has a great deal of room to the upside to catch up with the broader market.

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Finally, the Financials Select Sector SPDR provides investors with a blend of major institutions, some of which have outperformed the sector impressively such as JP Morgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Goldman Sachs (NYSE:GS) and U.S. Bancorp (NYSE:USB) along with other stocks that were most directly impacted during the crisis and continue to trail the overall sector by a wide margin such as Citigroup (NYSE:C), Bank of America (NYSE:BAC) and American International Group (NYSE:AIG). And given the broad diversification in business activities employed by all of these companies, they have various other profit opportunities to which to turn if the housing market were to reverse back lower.

For all of these reasons, the broad financial sector offers particular appeal to hedge a portfolio for a sustained housing recovery. Adding to the appeal is the fact that the sector sets up particularly well from a technical standpoint and recently broke out to the upside over the past week.

It should be noted that we are now entering what is likely the final stages over the coming months of a major bull market advance that began over four years ago. China is already tightening policy and the U.S. Federal Reserve continues to indicate that it will be scaling back on stimulus in the months ahead. Thus, any portfolio allocations including to financials, regional banks or homebuilders should be viewed with relatively short time horizons and managed carefully for any sudden shifts in market trends that may develop along the way.

Disclosure: I am long XLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.