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Anyone who has been following homebuilders over the past few months has likely observed a strong correlation between the group of publicly traded stocks and interest rates. Following Federal Reserve Chairman Bernanke's hint at reducing the asset purchase program on May 22nd, we really started to see interest rates spike. The correlation has had such a highly positive relationship that if you only showed me the yield change on the ten year US Treasury Bond, I could tell you with a high degree of accuracy whether the majority of publicly traded builders closed up or down for the day. The rationale for this correlation is logical, higher interest rates leads to higher mortgage rates, which leads to lower demand for new homes.

However when you listen to CEOs in the homebuilding industry, the demand they are experiencing for new homes seems to be going against the logical argument mentioned above. Regardless of the optimism amongst CEOs, the market has punished homebuilder stocks over the past few months leaving many analysts asking if this selling pressure is overdone. Given robust backlogs from all the major builders and the old adage "stock prices follow earnings" (which are once again growing and positive), one could easily argue that this industry is likely headed higher over the coming quarters and years.

(click to enlarge)Source: Yahoo! Finance

Unfortunately the market can remain irrational much longer then you can bear the pain of a losing position. And with major equity indices up roughly 18% year to date, it appears investors have temporarily avoided homebuilders, opting to look elsewhere for value. We are currently in a period where short term traders have control of these stocks and as the multitude of real estate data is released each month, coupled with daily movements in interest rates, the stocks of publicly traded homebuilders are exhibiting highly volatile characteristics. This presents an interesting opportunity however, as any investor knows that when fear is heightened in a particular sector, the best buying opportunities can be found. I am very bullish on the housing recovery and believe the majority of publicly traded homebuilders offer extremely attractive valuation levels given the anticipated demand which lies ahead. However my beliefs are not always correct, and if there is one thing investing has taught me, it is to respect the market at all times.

This led me to evaluate correlations in the homebuilding industry and see which names are most affected by this "interest rate crippling the housing recovery" theory. For those wishing to gain exposure to any publicly traded homebuilder, this study will provide you with some valuable insight to how the market is treating specific companies.

Brief overview and technical terms

My correlation study is short term in nature and only focuses on a limited period of time. I believe we have reached an inflection point last May when Bernanke spooked the markets and prefer to analyze current data rather than multi-year historical data to see how these securities are responding. To observe the change in interest rates I will focus on the ten year US Treasury bond. While some may argue that most mortgages are 30 years and the 30 year US Treasury bond would be a better fit (and I would agree), the ten year bond is much more widely followed and I feel gives a better perspective for investor sentiment. In my study I use the iShares Barclays 7-10 year Treasury ETF (NYSEARCA:IEF), to measure the movement in interest rates (keep in mind the inverse relationship between bond prices and yield to understand why I am using this ETF). The ETF has a negative correlation of -.99663 with daily movements in the 10 year Treasury yield (almost perfectly negatively correlated).

Next I looked at twelve publicly traded homebuilders:

  • Toll Brothers (NYSE:TOL)
  • Lennar Corp. (NYSE:LEN)
  • D.R. Horton (NYSE:DHI)
  • Pulte Group (NYSE:PHM)
  • KB Home (NYSE:KBH)
  • Standard Pacific Corp. (NYSE:SPF)
  • Meritage Homes (NYSE:MTH)
  • Beazer Homes (NYSE:BZH)
  • Ryland Group (NYSE:RYL)
  • Hovnanian Enterprises (NYSE:HOV)
  • NVR Inc. (NYSE:NVR)
  • AV Homes (NASDAQ:AVHI)

Keep in mind that this list does not include all builders in the industry. Some are left off the list, while others are part of larger conglomerate companies and the stock price does not accurately reflect the pure homebuilding operations (example Weyerhaeuser Co. (NYSE:WY)). I specifically left off the five companies which had IPOs this year given the limited trading volume which may skew the data (TRI Pointe Homes (NYSE:TPH), Taylor Morrison (NYSE:TMHC), William Lyon Homes (NYSE:WLH), UCP Inc. (NYSE:UCP), and WCI Communities (NYSE:WCIC)).

I observed three time periods in the study. The first period is January 2, 2013 (first trading day of the year) through August 30, 2013, a year to date measure. The second period is January 2, 2013 through May 21, 2013, the period leading up to Bernanke's tapering comments. The third period is May 22, 2013 through August 30, 2013, the period after the market began worrying about possible tapering at the Fed.

The results

The first table (below) is 1/2/13 through 5/21/13. The most important column to view in this table is the first column. Keep in mind that the Treasury Bond tracks the price of the bond, which is the inverse of the yield. You can see no clear correlation amongst the group of stocks and interest rates. Some exhibited positive correlations, others exhibited negative correlations. There was no truly predictable pattern between the industry and interest rates. This is likely indicative of an industry which is trading off of company specific fundamentals, not fear or speculation.

(click to enlarge)

The second table (below) shows how the same group of stocks responded during the period 5/22/13 through 8/31/13. This is an important period to observe because the market became extremely worried about rising rates during this time frame. As you can see in the first column, all the homebuilders (with the exception of AVHI) were highly positively correlated with changes in the Treasury bond ETF. If bonds were being sold off (rates going up), the stocks were being sold off as well. If bonds were being acquired (rates going down), the stocks were going up. It is interesting to observe that the highest correlation was exhibited by the most widely followed names, Lennar, D.R. Horton, KB Home, etc. The lowest correlation (excluding AVHI) was Toll Brothers. This is an interesting point and one I will focus on later. All in all, every homebuilder with the exception of TOL and AVHI had fairly high correlations to IEF.

(click to enlarge)

The last chart below is through the period 1/2/13-8/30/13 (year to date snapshot). You can see how much the period after May 22nd has increased the correlation among builders and rates. I also find it interesting to observe that the stocks with the highest correlations to interest rates are the most widely followed, Lennar, D.R. Horton, NVR (again excluding TOL which I will focus on later). It seems to me that the current market environment is quite irrational and focusing solely on most popular names to sell and buy when it comes time to making a trade. The high correlation with the most widely followed names provides significant evidence to prove my point regarding an irrational marketplace in this industry.

(click to enlarge)

My Final Thoughts

Although I am bullish on this industry, the recent increase in correlation with interest rates leads me to be somewhat cautious when building a large position in any of these names. While I believe long term investors have extremely attractive entry points in this industry, the short term price fluctuations may be too much for some to handle. Scaling into this industry may be the best course of action if you want to reduce volatility.

If you were looking to gain exposure to just one of the names above, my top choice would be Toll Brothers. In my recent article on the company, I cited the differing customer base they cater towards, an industry leading backlog, and declining cancellation rate. Couple these facts with the lowest correlation in the industry (following May 22nd and builders with a market cap above $1 billion), and it appears investors have a best of breed company to gain exposure to this industry.

Keep in mind that these models are not by any means exhaustive of the industry and do not cover a very long period of time. They are simply a snapshot of how the market is treating each stock during this period of heightened interest rate volatility. Consider your investment goals and objectives before initiating a position in and of the stocks mentioned above and remember that the value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Source: How Is Your Homebuilding Stock Handling Rising Rates? A Correlation Study