The Bottom For The Builders May Be In, Part II

by: John Gilluly

It has been a month since I wrote The Bottom for the Builders May Be In. In the interim, the yield on the 10-Year Treasury has lifted another 35 basis points from 2.6 to 2.95 (+14%) even though the builders are trading at the same level - or a little higher - than they were a month ago.

For all the reasons stated in my previous articles on interest rates - rising rates have an extremely negative effect on interest-rate sensitive equities - until the point where rates plateau.

We may have finally reached that point.

The SPX homebuilder index (NYSEARCA:XHB) has fluctuated within a 10% band over the last three months, while the 10-Year Treasury yield has risen 35% (See chart). This leads me to believe the worst of this rate-correction is over. Since bottoming a month ago, the builders have rallied at the slightest downward pressure on the 10-Year yield.

The Emerging Markets index - also sensitive to the 10-Year Treasury yield - seems to agree. It's actually up 3% in the last 3 months in comparison to the 35% rise in the 10-Year yield (chart). This comes only 10 days after we were told the Emerging Markets were in a state of collapse and on the verge of a multi-year bear market.

An interesting technical fact emerges when looking at some specific homebuilder stocks; their retracement levels. Many of them have given-back (i.e. retraced) 40% to 50% of their original rally off the lows of 2011.

In round terms - October, 2011 trough to May, 2013 peak to September, 2013 trough - DR Horton (NYSE:DHI) rose from $8 to $28 and then gave back $10; KB Home (NYSE:KBH) went from $5 to $25 and gave back $10; MDC rose from $15 to $42 and gave back $15; Brookfield (NYSE:BRP) went from $6 to $26 and retraced back $7; Lennar (NYSE:LEN) rose from $12 to $44 and gave back $13; Rylant (NYSE:RYL) went from $10 to $50 and gave back $17; and so it goes, through most of the builders' ranks.

Meanwhile, the demographics, which so many writers on this blog have mentioned - tight inventory, buyer demand, (still) "affordable" mortgage rates, a slowly rising job market, and long-term housing trends, which enunciate the need for shelter - continue to pull buyers off the sidelines and into new home communities. The momentum of record profits and record demand we saw earlier this summer has slowed down, but it's not gone.

In short, everything to do with new home construction and sales has moderated.

As long as mortgage rates remain fairly constant within a 4.5% to 4.9% band, a slight reduction (11%) in the construction footage of a new home should compensate for the recent rise in rates. Several builder CEOs have already mentioned this solution: encourage buyers to accept less home in order to complete a deal.

I think the current price of the builders has "priced-in" the recent rise in mortgage rates and their effect on buyer demand - relative to the profitable conditions, which now exist for the builders. As so many commentators have said, we are still in the early part of the real estate cycle.

The massive sector-correction of Summer, 2013 has taken the froth off what was becoming a bubble-like condition in California, Arizona, Colorado and Texas. Rising home prices increased the available inventory of existing homes, but rising rates have now mitigated demand and buyer traffic. A balance is being reached.

Commentators in the field continue the litany of buyer complaints: low inventory (few choices); tight credit (hard to qualify); higher mortgage rates (first-time buyers can't qualify) and multiple-offers from investors driving traditional buyers to frustration. Traffic is down, but prices have remained constant.

I think the next step forward for the builders will be a long consolidation period of several quarters accompanied by rising profits and growing book value - with slightly rising share prices and average selling prices for new homes - mitigated by cautious buyer demand and the hammer of mortgage rates.

If the Fed's proposed tapering occurs alongside rising IRS tax revenues, the effect should be nil. Treasury will be issuing fewer bonds, but the Federal Reserve will be buying fewer of them on both a nominal and percentage basis.

This is a "test" period right now. The Federal Reserve is assessing whether the ship of the economy can float on its own without an accelerator (QE), even as it continues its support of the economic recovery with a monetary policy of near-zero Fed Funds rates. What we are seeing in the highly-sensitive housing recovery is a barometer of that test.

Disclosure: I am long TPH, HOV. 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.