Background: Last May 28, I authored a negative article on homebuilding stocks on Seeking Alpha titled 5 Reasons For Caution On Housing Stocks.
My views then can be summarized by the following quote from the article:
I anticipate that the recent break in lumber prices and recent back-up in interest rates suggest caution on housing stocks in the short run. In the intermediate term, the valuation concerns I have delineated, which are almost irrelevant in the short term, then come into play.
Since then, the ETF I focused on, the iShares Dow Jones U.S. Home Construction ETF (NYSEARCA:ITB) has dropped about 7%, a dismal performance versus the average stock. ITB is comprised strictly of home construction companies. For a broader ETF, which includes not only home building companies but companies that are directly tied to real estate, check out the SPDR S&P Homebuilders ETF (NYSEARCA:XHB). This has also lagged the market, and is down less than 1% from its price on May 28, 2013.
Valuation has also been valuable in assessing individual homebuilding stocks. In my article, I criticized the valuation of Standard Pacific (SPF), as it was far above book value. Since then, SPF has dropped from $9.52 to a current $8.06, a particularly poor performance.
This article will update my observations on the industry.
Introduction: My sense is that homebuilding stocks garner a lot more interest and trading activity than would be expected by simply looking at their market cap. I think that some of the reason for that is the boom-bust nature of the industry. (My personal experience with a number of entrepreneurs in the industry supports this view.)
My sense right now is that most Americans and most investors think and tend to believe that housing is on its way to being fixed, and therefore the investing trend should be to go long the homebuilders. After all, look what the tech sector has done after its post bubble crash. The chart of ITB begs for that sort of sustained upturn:
The 2009-11 depressed period looks very much like the 2002-3 depression in the tech sector.
I concur with that reasoning, but I think it's premature to have more than a trading toe or two in the ITB or its constituents. Here are the bear reasons, followed by the bull points.
Reasons to avoid housing stocks:
1. Lumber futures are rolling over, again. Chartists may care that this represents a downturn from a lower high than in 2013, and there may be a break of the uptrending support line extending back to 2009.
From FINVIZ, the lightly-traded lumber futures chart:
As you can see, lumber had intermediate peaks and then declines in 2010 and 2011. These either coincided with or preceded drops in ITB. The same is true of last year, when I pointed out in the above-linked article:
Lumber prices have entered a bear market recently. This is not a great sign either for home construction or for the general stock market...
Indeed the falling lumber prices did presage that ITB was at a peak and was about to fall (over 20% from peak to trough). So this may be something to consider.
2. In addition to lumber prices, we can track the progress of plywood and oriented strand board, both used in panels. Per the most recent Random Lengths:
(f.o.b. mill prices) This Week
Random Lengths Structural Panel Composite Price* $365 $366 $514 Southern (west-east) 15/32-inch 3-ply rated sheathing plywood 379-417 377-417 475-495 Southern (west-east) 15/32-inch 4-ply rated sheathing plywood 387-419 385-417 485-512 Western 1/2-inch 4-ply rated sheathing plywood 383 388 450 North Central 7/16-inch Oriented Strand Board 215 215 430 *Weighted average of 11 key items
With the above came this commentary:
Another week of lackluster activity left traders scratching their heads and wondering when business would pick up. Prices were flat to down a few dollars.
Not encouraging for the housing bulls.
3. Some sober observers believe we are in a second housing bubble. From Political Calculations, "Ironman" (i.e. Craig Eyermann) has put together this interesting chart and commentary:
Now that the U.S. Census Bureau has finally posted the income data that it collected in January 2014 through the Current Population Survey (over a month late, the Bureau posted its data for February 2014 at the same time), we can now check in on the status of the second U.S. housing bubble. The chart below reveals what we find:
The ratio of income to new home price is very close to that seen at the peak of the bubble in 2005-6. Note that virtually all homebuilding stocks peaked in and around the summer of 2005.
4. Even Bill McBride, proprietor of the must-read Calculated Risk blog and someone who a year and more ago was insisting that the economic future of the U.S. was so bright we were going to need sunglasses to see it, has had to admit that the current housing situation in the U.S. is disappointing. From his post yesterday (March 26) come the following quotes:
The refinance index is down 72% from the levels in May 2013.
With the mortgage rate increases, refinance activity will be significantly lower in 2014 than in 2013...
The second graph shows the MBA mortgage purchase index.
The 4-week average of the purchase index is now down about 19% from a year ago.
The purchase index is probably understating purchase activity because small lenders tend to focus on purchases, and those small lenders are underrepresented in the purchase index - but this is still very weak.
Mr. McBride has been eerily accurate in his assessment of the housing market going back to the bubble. Combining Ironman's evidence that new home price income is near 2005-6 levels, with the above gloomy assessment of current conditions, leads me to favor the bear case for the housing stocks as more appropriate for me as an individual investor, at least for now.
5. The second derivative of the political trends are now moving against housing. There are other priorities now at the White House, in Congress and at the Fed. The Fed, for example, is withdrawing its extraordinary support of the mortgage market. No new programs are forthcoming from the administration or Congress to support housing that I am aware of. Uncertainties about the future of government's role in mortgage financing are not helpful to housing stocks, either.
6. Very broadly, this is the seventh year since the last recession began. It is about five years since that Great Recession ended. Thus this is late in the business cycle; housing stocks are early cycle stocks. Think back to 1999-2000 as well as 2006-7. In each case, housing faltered as more cyclical industries saw their stocks soar.
7. Valuation of the underlying stocks comprising ITB is less unattractive than a year ago, but remains uncompelling. From Yahoo! Finance, here's the valuation of the stocks in ITB:
Ratio ITB Average Price/Earnings 18.43 Average Price/Book 2.09 Average Price/Sales 1.11 Average Price/Cashflow 5.16
Here's a little history. Before the housing bubble, a rule of thumb was to buy the homebuilders at book value and sell at double book. The thinking was that the major asset of these companies was their inventory of completed or (mainly) uncompleted homes plus land. As it cost them money to maintain the inventory, the investor would make a profit by buying into a company at the company's cost. As the company turned its inventory of completed homes or land, or work-in-progress, into a profitable venture, the investor profited as well.
I think this continues to apply. Thus I find the P/B of 2.09 to be unattractive, though not horrible. Similarly, after so many years of Fed manipulation of the interest rate, countless Federal programs, etc., an average P/E of 18.4 is not compelling. Meanwhile, one can buy top-tier tech stocks at lower P/E's, with steadier and ultimately more rapid growth.
The bullish argument:
In contrast to the above, the bull case is strong on a longer-term basis. It is as follows. The stocks in ITB represent the survivors of the greatest shakeout in the industry since the Great Depression. Be patient, and economic and population growth, plus inflation, and ITB will in its own pattern return to its all-time highs. Don't try to time it, just buy and hold. Housing is close to the single most essential industry after food; your money should be exposed to it.
Conclusion: I actually agree with both the cautious/bearish point of view and with the bullish argument. Thus I am patiently long a very small amount of homebuilding stocks, having taken profits on ITB itself and one specific name that is underperforming ITB. But on the whole, I believe that market timers who are looking to outperform the market in the months ahead have better-looking sectors and individual stocks than ITB, XHB and related securities.
However, long-term investors may in my view rationally look at homebuilding stocks as depressed from their highs, extrapolate to the NASDAQ/tech stocks/QQQ etc. after their crash, and own the sector in a significant way.
Disclosure: I am long TOL, MDC. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.