The recent two years of self-induced government fiscal crisis have been quite an education for investors in the homebuilder sector; revealing the unique intertwining of government activity and the Federal Reserve with the home building industry.
First of all, a little history.
In the summer of 2011, the Federal Reserve ended its stimulus spending program (QE2) coincident with the government's first Debt-Ceiling crisis. The SPX500 dropped 19%; and several stocks in the homebuilder sector - like Pulte (PHM) and KB Home (KBH) - fell 50% to 15 year lows.
In the summer of 2013, the Federal Reserve contemplated tapering-back its third stimulus spending program (QE3) - the likely commencement being at the September, 2013 FOMC meeting. But as timing would have it, taper-talk preceded Debt Ceiling Crisis #2 and the government-shutdown of October, 2013.
The mere mention in May 2013 of the soon-to-be taper spooked the bond market into a rapid sell-off. Interest rates rose by 35%. Homebuilders shares dropped by 35%. In the span of just 3 months, mortgage activity was cut in half (back to financial crisis lows) and the economy cooled. The effect of the higher interest rates on the economy was already apparent by the September labor report.
Alarmed at the rapidity of the pullback, and aware of the intransigence on the fiscal front from Congress, the Federal Reserve switched course and demurred on the date for tapering. Fed-watchers now push the date forward to the Spring or Summer of 2014.
After the switch, mortgage rates receded back towards 4.2 % and investment activity in the homebuilders picked up again. Several homebuilders have since recovered half their losses from the May highs. (See The Bottom for the Builders May Be In, September 11, 2013).
Considering the effect of both the debt-ceiling debate and the protracted Government shutdown (17 days) on business and the national psyche; the Fed's decision "not to taper" appears prescient. In fact, the rare perplexity of the Fed Chairman last summer regarding the tapering date may have been related to his fear of another government shutdown and its upcoming effect on the economy.
Most analysts now believe the recent government crisis created a 6 month lag in the economy.
THE MAIN TAKEAWAY
The housing recovery is extremely sensitive to interest rate fluctuations.
Investors in homebuilders need to always keep an eye on this all-important barometer.
At this point in time, the bond market has become transfixed on the idea that interest rates CAN ONLY GO UP, even though the effect of the Federal Reserve's bond buying program (QE3) should be to push rates down.
This bearish mindset has held back investment in the home builder sector and made it one of the worst performers of 2H2013, even as public home builders continue to post record profits on slower sales.
It's a confusing time. I don't know if anyone knows how to value interest-rate-sensitive stocks at this juncture. On the one hand they have been subsidized by the Fed for 50 out of the last 56 months, and on the other hand, the sheer volatility in price of late implies rampant uncertainty. In my experience, this usually occurs just before a trend change.
The simplest thing for the FED to have done was a conservative timetable for tapering, with the direction that it would be tiny nominally at the start, and could be edited at any time.
In this way the Fed could have kept some of the reset in expectations that mere jawboning had brought about since May, without throwing away the whole 4 month exercise in anxiety.
What the low to lower to lowest interest rates have done over the last 30 years is increased people's purchasing power (vis a vis debt) without an attendant rise in personal income. In short, expenses have been cut, but personal revenue relative to inflation has been flat. Against that backdrop, the recent 150 bps rise in mortgage rates made every 30 yr mortgage in the states rise 30% in cost. That's a bite; a real bite. And we live in the nominal world.
Consumer sentiment has fallen off a cliff since May; foot-traffic is down to recessionary-lows at new home communities, about 40% below a year ago, equal to the 2011 depressed averages of foot-traffic; the housing affordability index has dropped from housing-recovery highs to 4 year-lows in just 5 months.
The Federal Reserve made a recent policy statement that it is determined to support the housing recovery, and worried about the harmful effects of the rapid rate-rise in yields on the housing market. (See: Bernanke Giving Homebuyers Second Chance With Pledge: Mortgages, by Kathleen M. Howley, 2013-11-05)
But the bond market appears just as certain that interest rates are on a recovery-killer trajectory for housing, exactly the opposite of what the Federal Reserve intends. Front-running the Fed - and believing that this is so - has created its own reality.
Raymond James Research recently correlated the Bloomberg Weekly Economic Index with the S&P 500 at all-time highs. Their chief investment strategist, Jeffrey Saut, commented that it was the biggest disconnect he could remember, adding that the new highs were in spite of downward revisions to GDP for 3Q2013 and 4Q2013.
The housing sector was vibrant when ten-year yields were in the 1.6 to 2.6 range (3.4% to 4.2% mortgage rates); and cooled when mortgage rates rose above 4.5%. There had been a strong housing recovery in 2012-2013 when rates were below the 4% mortgage band. At this point in time, 4.5% mortgage rates appear to be the ceiling point above which buyers become reticent.
Credit Suisse's October Survey of Real Estate Agents mentioned 3 culprits for the recent slowdown: interest rates, lack of inventory, and escalating prices.
Interest rates are controlled by the Federal Reserve and bond market; but the second two - lack of inventory and higher prices - can only be resolved by new home construction and increased supply.
The summer experiences of 2011 and 2013 should make the Federal Reserve loathe to pursue any future policies that inhibit real estate growth.
Main Street's economic recovery is intimately tied to the construction cycle. New-home communities add schools, shopping centers, roads, city services, property-tax revenues, and a host of ancillary jobs tied to economic growth. New housing is one of the best economic multipliers around. (View this video to see the effect of Buy American on the domestic economy).
The Federal Reserve has three challenges ahead. The first is the commencement of a tapering program (the end of QE3) concurrent with a rise in economic conditions, and hopefully without losing control of the bond market (again).
After the negative summer experiences of 2011 and 2013, that's a tall order. But similar to the previous two attempts, the third attempt will likely be this Summer, 2014; thereby setting-up a third "Sell in May and Go Away" event for real estate investors.
The second challenge is the continuing legislative dysfunction in the government. It has been a de-stabilizer to consumer confidence.
The third challenge comes when the Federal Reserve decides to raise the Fed Funds rate.
In my view, the Federal Reserve will remain extremely cautious with interest-rate rises for the remainder of the decade.
It's true that there has been a marked slowdown (-45%) in new home sales in the West region since the Fed's first taper call in May, 2013. Even so, reporting builders nationally (October, 2013) have also said they could not replace homes-for-sale fast enough, and did not want to sell through their valuable land inventory too quickly.
Although there's been a slowdown in traffic and orders, there's been virtually no slowdown in profits, or in plans for the upcoming Spring selling season. Builder confidence remains at 7 year highs, having risen to median levels consistent with housing recoveries for the last 28 years.
But homebuilder stocks stubbornly remain near yearly lows, which leaves investors wondering, is this a temporary pause in the recovery, or the start of another leg down?
The builders, on the other hand, are preparing for a robust 2014 in new home construction, anticipating that purchases of single family homes will play catch-up with growing job creation in desirable geographies.
For example, look at these two graphs (Job Growth & Building Permits) for San Diego County, CA. Job growth has recovered 70% of its losses since 2007, while building permits have recovered only 30%. This catch-up plays throughout Coastal CA, and it's why I have focused my analysis (and some of my purchases) on companies that cater to this market [KBH, Meritage Homes (MTH), TRI Pointe Homes (TPH), Standard Pacific Corp. (SPF), Lennar Corp. (LEN), Brookfield Residential Properties (BRP), Toll Brothers (TOL)].
Interest rates had a dampening effect on sales in the Northeast, South, and Midwest regions (Charts), but sales have also quickly recovered in those regions. For this reason, I think that builders with the broadest national coverage [e.g. D.R. Horton (DHI), PHM] will show the greatest near-term growth in sales and profits.
Lastly, I do not believe the Federal Reserve will rebuke its own advice to proceed cautiously regarding interest rates. If the homebuilder routs of 2011 and 2013 have taught the Feds anything, it should be extreme caution.
"Needless to say, the future path of house prices will depend not only on the trends in housing, but also the condition of the overall economy, including the unemployment rate ...
Expectations of economic conditions and future house prices ... play a significant role, as do interest rates. If prospective buyers expect home prices to decline, they are more likely to postpone purchasing a home in favor of renting. Also, if long-term rates rise, the recent slide in mortgage rates could reverse; such a move, in turn, would dampen mortgage demand.
Weaker job growth and higher mortgage rates are unlikely to spur demand for housing. Until people feel the economy's prospects are definitely getting better, they will remain less likely to buy a home."
(From Rajdeep Sengupta & Bryan Noeth, Federal Reserve Bank of St. Louis, "Have the Trends in Housing Bottomed Out?", from the Regional Economist, January, 2011).
Finally, there is no reason for the Federal Reserve to begin raising nominal rates. The year over year percentage growth in the consumer price index has continued to be under 2% for the past 18 months, a span that includes the sub 4% mortgage rates of 2012-2013. (See also "Consumer prices in October near their lowest point in 50 years" by Hale Stewart, October 30, 2013.)
I'll close this article with a little anecdote from the last housing cycle (1990-2005). In October of 1990, Pulte Homes bottomed at 45 cents and rallied 600% in the next 17 months to $3.20. On a brief interest-rate reversal it dropped 40% in 5 months to $1.80, and then turned right around to rally an additional 14 months to a new high of $4.60 in February, 1994 (this last leg was accompanied by lowered interest rates).
In October of 2011, Pulte bottomed at $3.25 and rallied 600% in the next 19 months to $24.10. On a brief interest-rate reversal it dropped 40% in 3 months to $14.25. It has been recovering for 2 months since then on a gradual drop in interest rates.
It remains to be seen what happens next.
As long as the threat of higher interest-rates hang over the home builder sector like a sword of Damocles, it doesn't seem to matter (yet) what the builders report or what they plan to do.
As I said earlier, the market is transfixed on the idea that rates CAN ONLY GO HIGHER - the reasoning being that better economic conditions will hurt the home builders (higher interest rates); and poor economic conditions will also hurt them because of diminished sales.
At this point in time, all news seems "bad" news for the builders - if it's good it's bad, and if it's bad it's bad - which is having its own effect on confidence and keeping investors away from this sector.
A surprise resolution to this crisis-thinking vis a vis interest rates would be sorely welcomed by the sector as we move towards the final months of the year and the upcoming Spring selling season. If rates can remain in a narrow band between 4.0% and 4.5%, I think the upcoming earnings reports will herald solid demand and begin a new leg up for the builders. They could again rise from worst to first.
But if rates soar into the 5%+ range, I think the monthly mortgage cost will prove too much for buyers and builders; traffic will hit new lows for the year, and the housing recovery will sit dead in the water. It's a stark contrast of choices, and it needs to be resolved for this most-volatile of sectors.
Higher mortgage rates would also have the unwanted side-effect of flat-lining an already stark inventory, and raise average selling-prices for new homes even further. Fewer people would buy less home, but at higher prices. To normalize the market for buyers - especially first-time buyers - the sector needs credit relief and plenty of new inventory.
At this point, that's still on the wish list. (See: Credit Cuts Out Would-be Homebuyers, by Diana Olick, November 5, 2013)