Builders Up, Builders Down - Who's Right?

Includes: BRP, CAA, KBH, LEN, RYL, TPH
by: John Gilluly

It's been a tough 3 month slog for the homebuilders and their investors. Let's take a look at the real-time data surrounding the builders and see where it is trending now.

First off, the news cycle. The bears have returned to the catbird seat and are exceedingly popular again. All news now seems to be bad news for the builders.

Interest rates are rising and mortgage rates have drastically reduced the pool of buyers. In just 3 months, mortgage applications have fallen to their lowest level in 3 years, down 50% from a year ago. New home sales are down 13% in a month. There has been a rapid 100 bps rise in lending costs, which cannot be easily absorbed by a labor force that has seen little real wage appreciation (relative to inflation) for decades.

Every rally in the builders has been clawed to pieces. The stocks trade down for days on end, and then suddenly spike upwards 6 to 10% in a single day, only to give it all back in the days ahead. There's NO follow through. This is classic bear market action. It is hard for me to imagine the Federal Reserve tapering its asset purchases amidst this kind of engineered slowdown.

What realtors in the field are saying:

1) Investors are quietly exiting the market and traditional buyers are once again becoming the main focus of sales. This has been a sea change over the last two months. (See Homeowners Surge, Investors Slump).

2) Foot-traffic is receding; but the price of new homes remains high because of the tight inventory. Instead of 10 bids on a home, now there are two or three. Realtors everywhere are saying that buyers are dismayed at the lack of inventory and are balking at the high price of lackluster offerings.

Yet there is another way of looking at this outcome. The builders are playing this cycle masterfully, eschewing speculation and prudently metering out their new home construction as they go, comfortably remaining under the demand curve.

In other words, the tight inventory of new homes is no accident. You might even call it collusion by a cartel, that handful of public builders who survived the housing recession and learned what it takes to be a survivor in this business. They have not returned to bubble-days ways. By right-sizing their inventories, they should remain profitable even with reduced starts. This is the one thing the bears don't seem to get.

By keeping construction starts just above all-time lows - while the demographics of rising jobs, new families and growing population places upward pressure on the supply of single-family homes - the builders are playing against time and ensuring their profits. These guys aren't dummies, and they've done their research.

Here is a simple graphic of the real estate cycle from John Burns Consulting. Of note, this animation was published in March, 2009, at the bottom of the financial crisis.

3) Getting a mortgage from a bank is tight, but not as tight as two years ago. Average FICO scores have fallen from the 750s to the mid 730s.

4) The Federal Reserve has been a model of confusion of late. In a rare but momentous slip at a Q&A, the Chairman mentioned tapering back on the Fed's asset purchases later this year if the data warranted it.

The next day, a tsunami of selling swept over the bond market. It began pricing-in six 25 basis point moves by the Fed. Mortgage rates rose 100 basis points in a month. The comment set off currency devaluations in the emerging markets, and the currencies of India, Malaysia, and Brazil began fighting for their collective lives.

Here in the states, fixed-income portfolios, REITs, and employment in mortgage-banking crumbled, while the rise in rates clearly cooled the housing market. It was as if someone had flipped a switch.

Dismayed, a month later the chairman called the rise in rates "unwarranted" and said the Federal Reserve has no intention of raising rates because that would kill the recovery. In a sense, the bond market has been "fighting the Fed" all summer.

Here is a transcript of what he actually said as way of explanation at a press conference on June 19, 2013:

" ...One thing that's very important for me to say is that, if you draw the conclusion that I've just said, that our policies-that our purchases will end in the middle of next year, you've drawn the wrong conclusion because our purchases are tied to what happens in the economy. And if the Federal Reserve makes the same error and we overestimate what's happening, then our policies will adjust to that.

We are not-we have no deterministic or fixed plan. Rather, our policies are going to depend on this scenario coming true. If it doesn't come true, we'll adjust our policies to that." (Page 8 of 28)

"..the other thing I wanted to say was that stopping asset purchases, when that happens, and I think we're still some distance from that happening, but when that happens, that won't involve ending the stimulus from asset purchases because we're going to hold on to that portfolio. And if the stock theory of the portfolio is correct, which we believe it is, holding all of those securities off of the market and reinvesting and still keeping the, you know, rolling-over maturing securities, will still continue to put downward pressure on interest rates.

And so, between our commitments to a low federal funds rate and the large portfolio, we will still be producing a very large amount of stimulus-in our view, enough to bring the economy smoothly towards full employment without incurring unnecessary costs or risks." (Page 13 of 28)

The three things the Federal Reserve is looking for before reducing asset purchases:

"...Our basic forecast is one which is...a moderately optimistic forecast, where (1) growth picks up as we pass through this period of fiscal restraint; (2) where unemployment continues to fall at a gradual pace as it has been since last September...; and (3) inflation rises slowly towards 2 percent. Those are the conditions that define this sort of baseline forecast." (Page 21 of 28)

Here is the chairman's summary of the effect of Federal Reserve asset purchases (QE) on providing liquidity and lowering interest rates:

"...I think you would say that if the Fed cut the funds rate by 25 basis points, that was an easing of policy. And, by the same token, as long as we're buying assets, we are adding to our holdings. We do believe...that the primary effect of our purchases is through the stock that we hold, because that stock has been withdrawn from markets, and the prices of those assets have to adjust to balance supply and demand. And we've taken out some of the supply, and so the prices go up, the yields go down. So, that, seems to me, consistent with the idea that we're still adding liquidity, we're still adding accommodation to the system. (Page 22 of 28).

In summary, the chairman is mildly optimistic about the economy's progress as we enter the back half of the year, and Fed policy remains completely open-ended and accommodative towards housing. If we are to take his comments at face value, the Fed's asset purchases of Treasuries and MBS fly in the face of the massive selling of Treasuries this summer. And if unemployment falls a further 100 basis points to 6.5% it should be stimulating to the housing market, not a negative.

The dynamic yield curve is consistent with an economic recovery; the prevalence of part-time employment in the recovery (as opposed to full-time employment) should not be a concern to date - it's common to previous recoveries. And our economy is truly entering an expansion phase - not a contraction. (See: Business Cycle Forecasting: The Superlative Results of Robert F. Dieli).

The question we have to ask ourselves as investors is this:

"After a 35% correction, are most of the contingencies baked into the share prices of home builders?"

I think they are - or very close to - and it's time to re-enter some of these positions. I especially like the builders who derive large revenues from CA, [TRI Pointe Homes (TPH), Brookfield Residential Properties (BRP), KB Home (KBH), Ryland Group (RYL), Standard Pacific (SPF), Lennar Corp. (LEN)], where job growth has been some of the highest. These offer the best upside.

Disclosure: I am long TPH, BRP, KBH, GFA. 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.