Homebuilder ETF Rises Despite More Bad Housing News

The last time we profiled iShares Dow Jones U.S. Home Construction ETF (ITB) in October 2006, the fund was dead last on the ETF Momentum Tracker Table. At that point there was no doubt that the housing market was in rough shape—but it seemed possible that homebuilding stocks might have hit bottom. That wasn’t the case. In fact, the fund fell almost continuously through 2007, losing nearly two-thirds of its value.

But since January, homebuilding stocks are on the move and ITB has built momentum. The fund gained more than 17% year to date through May 2, outperforming 96% of the funds in Morningstar’s mid-cap blend fund category and topping the S&P 500 by a whopping 20 percentage points. Still, ITB has a long way to go to fully earn back its decline—and there’s a chance the fund might simply be experiencing another short-lived swing in investors’ perceptions of the hard-to-read housing market.

ITB invests in stocks of 21 U.S. homebuilding companies. Most funds that focus on homebuilders offer some exposure to home-supply retailers, construction firms or real estate companies, but ITB takes a pure-play approach to the industry. Most of the companies in this industry are quite small. The largest homebuilder in the U.S., D.R. Horton (DHI), has a market capitalization of only $4.9 billion—and overall, ITB’s portfolio recently had an average market capitalization of only $979 million. In fact, Morningstar classifies more than 40% of the fund’s holdings as micro-cap. The fund’s portfolio is also highly concentrated, with more than 55% of its assets typically invested in its top 10 stocks.

Any fund that invests the majority of its assets in a handful of tiny firms is sure to perform with intense volatility. That quality has been magnified in recent years, as homebuilding companies have endured the worst housing market in generations. Since its inception two years ago this week, ITB has suffered from dramatic swings—most of them downward—and has lost nearly 60% of its value.

Single-family housing starts declined 63% from a 2006 peak through March, nearly matching the 66% drop in housing starts during the downturn of 1978 to 1981—and the current downturn could last considerably longer. Morningstar analyst Eric Landry predicts that the market will eventually register the steepest drop in housing production in 60 years. “Home prices are likely to be pressured for several more quarters, as there's now anywhere from 1 million to 2 million surplus homes for sale, a large majority of which are sitting empty,” Landry explains.

New data released in the last few weeks support Landry’s assessment. The S&P/Case Schiller Home Price Index reported that the price of single-family homes (excluding new construction) in 20 major U.S. cities dropped almost 13% in February from a year earlier. Landry believes that most of the “formerly hot markets” have made it anywhere from halfway to 90% of the way through the correction process, leaving a long way for some markets to fall.

If the housing bust drags on, some of the more vulnerable firms might not make it to the other side. Several homebuilders have already gone bust, and several of ITB’s holdings could join them. Standard Pacific (SPF), Beazer Homes (BZH), WCI Communities (WCI) and Hovnanian Enterprises (HOV), all of which were recently in ITB’s portfolio, are likely candidates for bankruptcy or acquisition.

A prolonged recession in the U.S. likely would make a difficult situation much worse. Good news on that front came last week, when the Department of Commerce reported that the gross domestic product grew at an inflation-adjusted rate of 0.6% in the first quarter of 2008, surprising analysts who expected a lower or even negative figure. The report carried more bad news for the housing sector, however: The housing market experienced a 27% decrease in investment, shaving 1.2 percentage points off the country’s total GDP.

Nevertheless, investors have taken recent signs of a firming economy as good news for housing stocks, which trade at rock-bottom prices. ITB has rallied as a result, which has led to rising momentum. The fund jumped 26 spots on the ETF Momentum Tracker Table between March 11 and last week, leaving it ranked 18th. Moreover, only one of ITB’s top 20 holdings showed a year-to-date loss through May 2, and 10 generated gains of more than 20%.

Eventually, the housing market will boom again, and investors who snatched up stocks when they were beaten down will benefit handsomely. But with so much uncertainty still plaguing the homebuilding industry, investors interested in this fund would be wise to take a cautious approach.

Comments

[thel337:]

This ETF is overdue for a plunge. Home Builder stocks do NOT reflect the reality of unavailable credit and consumer buying power.

2008 May 09 07:45 AM

[karchad:]

The ETF had it's plunge already, down to 13. It's a great buy. I'm in since beginning of year at about 17. Long term, you cant beat a sector that's down 70%. Heck, if you're a long-term investor, and you're not buying something like this, exactly when ARE you going to buy??? If you're not buying, you're not a long-term investor, you're a market timer.

2008 May 09 09:00 AM

[mlambert890:]

Great point karchad... OR, as Im noticing increasingly, a "doom predicter"

A lot of folks these days, I think, are just trolling financial forums to hear themselves rant and have it validated by other commenters. Its like a support group and these guys are like the guy on the corner with the "WORLD IS ENDING" cardboard sign.

Its simple really. Either the world is ending or it isnt. If you are like me and karchad, start consdering buying sectors that are right now highly depressed for the long haul.

If you believe the world IS over, stop blogging and ranting about it, turn off the computer, start taking physical delivery of commodities, and go dig a bunker.

There really isnt any other option here. Things are either going to recover AT SOME POINT, or they're not. Endlessly predicting the Great Depression 2.0 only now 5x worse is pretty much a waste of time.

2008 May 09 09:19 AM

[Randy_H:]

No GreatDepression 2.0, though the chances of that occurring were higher late last year. But the world's central bank actions have largely averted systemic meltdown.

But, and this is a big but, if you're going to "go long" homebuilders then you had better consider the health of your balance sheet. There is a very real cost to sitting in a sector "for the long haul" at below market returns in an inflationary environment.

Everyone is a market timer whether you like it or not. Time waits for no man. It's all a matter of how you choose to optimize your inputs. But, make no mistake, mathematically there is no such thing as a "market timer".

2008 May 09 10:06 AM

[stockmarket...:]

The housing market worldwide during 2004-2006 was probably the biggest financial mania ever in terms of its financial and geographic scope. It will take many years to form a good base to recover from. In the meantime we'll have tradeable rallies from time to time which are doomed to fail. This is just one of them.

2008 May 09 10:20 AM

[User 143167:]

For a sector that was down 70% to is down 80% is quite normal, but for those who get into it at down 70% will lose another 33%.

2008 May 09 11:28 AM

[sf123:]

Does anyone know what is the price/book ratio for ITB?

2008 May 09 11:31 AM

[DaveW:]

mlambert890 and karchad can go 'all in' just like Jack Yetiv did with TMA when it was trading at $10. Now TMA's as what, $0.88? You just can't go with a gut feeling that a stock or sector has been 'punished enough' if the fundamentals suggest otherwise. I am a bull or a bear when fundametnal support either mindset. I'm with 143167, get ready for more punishment in homebuilders.

2008 May 09 12:33 PM

[Joe Friday:]

I am on the bear side of this debate as well. One would not buy this index today unless you thought we were near a bottom in the housing decline. Even if you are a long term holder, you still want to enter your position when it is most advantageous (ie cheapest). There is no indication that the housing market is anywhere near a bottom. All indicators show that there is much more pain to come, and many of these homebuilders will default on their loans, resulting in the total elimination of their 'equity'. Buy the index if you believe we are close to a bottom, otherwise, avoid it.
I beleive many of these HB stocks will not survive.
Question for discussion, which one of them is most likely to default. My premlinary thought is CTX. Lots of land inventory in terrible markets, and 60% leverage on the balance sheet. Other thoughts?

2008 May 10 09:56 AM