The Bottom For The Builders May Be In

by: John Gilluly

[Editor's Note, August 15: This article has been revised since original publication, as the author has added extra content]

Today may be the turning point for the hard-pressed home builders. As I write, the Dow is down 220 pts; the 10-year yield has risen 8% in just three days - but some builders (PHM, MDC, KBH) are already up 7% from their morning lows, and most are actually green for the day. This is a sector that has been hammered down almost 40% from its May highs.

The sudden reversal may indicate we have reached the inflection point where the perceived strength of the economy - and the jobs it will create - are trumping the rising cost of housing through interest rates.

Think of it as a soup cooking on a stove in a pot. The ingredients are heat, water, and vegetables. The buyers and builder sentiment are analogous to the heat (the flame). The vegetables are the demographics: housing inventory, population increases, employment developments, building permits and housing starts. And the water - the liquidity - is the Federal Reserve's interest rates plus the availability of finance.

What happened in May was a gigantic block of ice - a 50% rise in interest rates (100 BPs) - thrown into the soup, and builder share prices cooled immediately. But the other ingredients were still there, and no one turned the flame down on the burner. In fact, it's been turned up, and now there is kind of a stasis, where the housing market remains hot (good soup), but not overheated or burned. To keep the recovery going, small rises on the 10 year yield (cooling) would need to be accompanied by jobs, rising incomes, and more-available credit.

The Homebuilder's Confidence index came in at an 8-year high this morning (see article and chart of the Index).

Some highlights from the announcement:

The National Association of Home Builders/Wells Fargo builder sentiment index released Thursday jumped to 59 this month from 56 in July. It was the fourth consecutive monthly gain.

A reading above 50 indicates more builders view sales conditions as good, rather than poor.

The last time the reading was above 59 was in November 2005, when it was 61. U.S. sales of new homes peaked in July that year.

Measures of current sales conditions and builders' outlook for single-family home sales over the next six months each increased to their highest levels in at least seven years. Builders' gauge of traffic by prospective buyers was unchanged.

Steady hiring, rising home prices and still-low mortgage rates are encouraging more people to buy homes. New-home sales jumped 8.3 percent in June to a seasonally adjusted annual rate of 497,000, the fastest pace in five years.

That's still below the 700,000 pace consistent with healthy markets, but represents an increase of 38 percent over the previous 12 months, the biggest annual gain since January 1992.

The mention of 1992 is significant, because it was in the 1991-93 timeframe that homebuilding stocks rallied 600%; only to give back half of that over the next year as interest rates rose 280 basis points (See: When Will the Builders Be a Buy Again for the 20-year history of interest rates vs. Pulte's stock). But as soon as the rise in interest rates receded, the homebuilder shares soared again.

Today's rally in the builders, combined with scarce inventory, anecdotal reports of intense buying interest, and positive prospects for the economy, may be the signal that now is the time to re-enter these hard-pressed names (TOL, TPH, KBH, MDC, RYL, SPF, PHM, MTH, HOV, DHI).

J Gilluly 8:25 AM, PDT

Disclosure: I am long TPH, URE, GFA. 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.