A Housing Pullback In 2017?

| About: Vanguard Real (VNQ)
This article is now exclusive for PRO subscribers.

Summary

The bond market unleashed one of the fastest adjustments to risk premia in the wake of the Trump Electoral College win in recent years sending prices plummeting and yields soaring.

The housing market is uber-sensitive to interest rates and recent volatility in the bond markets have whipsawed home builders. Home prices continue to outpace wage growth.

Interest rates will continue to rise as bond markets view the incoming Trump administration as a reflationary catalyst. Home builders will likely struggle in 2017.

According to data compiled by the Federal Reserve Bank of New York, the 10-year term premium moved above zero for the first time in 10 months on the 14th of November, less than a week after Mr. Trump's surprise Electoral College win. This means investors were quickly being forced to pay significantly more for a risk-free Treasury note than would at the time have been expected given prevailing expectations on both inflation and real interest rates - all within days of the election. On the last day of trading for the year, the yield on the benchmark Treasury note stood at 2.42% - 1.05 percentage points higher than July's yield of 1.366%, an all-time record posted in the wake of the Brexit vote. Most of these gains are likely attributable to surging risk premia.

Surging yields over such a short period of time are rare in the bond world. The biggest single day jump in the 10-year yield was logged between the market close on the 29th of May to the close on the 1st of June in 2009 when General Motors filed for bankruptcy. The 10-year benchmark soared 24 basis points (b/p) as a government bailout of the auto industry was being quickly patched together. Another came in October of 2011 when the financial ministers of the European Union announced a debt agreement that kept the single currency bloc from implosion. From the market's close on the 26th of October to the close on the 27th the benchmark exploded for 28 b/p. From the market's close on the 8th of November through the market close on the next day, the yield on the 10-year note increased 19 b/p.

The bond market sees the world through binary spectacles: events are either inflationary or deflationary. The incoming Trump administration is unquestionably viewed as a reflationary catalyst. Millions of dollars in capital gains were forced on fixed income investors as prices swooned while yields surged to two year highs. Talk of spending $1 trillion on infrastructural projects across the country - irrespective of project white papers or spending offsets - would require a big increase in the supply of Treasury notes to fund the venture. While cutting corporate taxes is likely a sure-fire way to boost earnings and promote forward capital investment, such a fiscal shot in the arm would also be expected to place strong upward pressure on prices across the greater economy. The Federal Reserve would be certain to respond to an uptick in inflation with an accelerated program of interest rate hikes.

One of the most sensitive sectors of the economy to rising interest rates is the housing market, especially for those home buyers that have to venture into the credit markets to finance their purchases. The week ending 5th of January, the 30-year fixed rate hit 4.20%. The 30-year benchmark stood at a post of 3.54% the week ending the 3rd of November leading up the election. The year low of 3.42% on the 30-year benchmark was still in play as late as the week ending 6 October - a strong directional signal for mortgage rates and possible headwind for the housing market for the New Year.

Existing home sales, which is about 90% of the overall market, were up for the third consecutive month, reaching 5.61 million annualized for the month of November. The month's total was up 15.4% year-over-year. Geographically, all four regions posted double digit gains with the national median price for all housing coming in at $234,900, up almost 7% on a year-over-year basis. Single family home prices were up 6.8% to $236,500 while condominium prices were also up 5.8% to $222,600, year-over-year.

New home sales during the month reached an annualized, seasonally adjusted rate of 592,000 during the month of November, an increase of 5.3% month-over-month and a 16.5% increase on November 2015. The post was driven almost exclusively by a whopping 43.8% surge in new home sales in the Midwest region where home prices have been the least explosive in comparison with the uber-priced Northeast and Coast markets and the high growth snow-bird retirement areas of the South and Southeast. The median sales price rose to $305,400, up slightly on October's post of $302,700 and down almost 4% on November 2015. The average selling price in November was $359,900 which signals overall sales continue to skew toward the high end of the market. The current median price post in November is down just over 5% from a high of $321,600 set as recently as June of this year on data that extends back to 1963. November's median price is almost 3-times the median new home price of $124,003 of the data set.

The S&P Case Shiller Home Index saw its pre-election 20-city composite measure increase by 5.12% through the month of October. The Index's national measure was up even more at 5.6% over the same period. Since July 2015, the 20-city measure has posted above 5% in 15 of the past 16 months with the cities of Portland, Seattle and San Francisco largely driving the upward tick of the Index over the period.

Anecdotally, the beehive of housing activity during the month could be indicative of a frantic attempt by homebuyers in need of financing at locking in pre-election interest rates:

  • Pending home sales, those homes under contract but have not yet closed, fell 2.5% during the month of November to a reading of 107.3, down from October's reading of 110.0. The post was the lowest post since January and possibly the best forward indicator to date of the impact of rising interest rates on home sales across the country as the bond market raced to price in the added risk premium of the surprise Trump electoral win;
  • Single family homes declined 0.4% during the month from October while condo sales were above 10% for the month. Both single home and condo sales were up in double digits year-over-year;
  • Mortgage lenders are anticipating the demand for refinancing existing home debt at levels last seen in 2000. About $8.2 trillion worth of refinancing has been completed since interest rates began to drop precipitously since 2009. About $901 billion worth of mortgage refinancing activity is slated for completion through the end of 2016, an increase of about 16% over 2015 according to data from MBA as the sharp sell-off of government bonds has flooded banks with refinancing applications during the month. For 2017 the estimate drops by about half to $479 billion - the lowest level in the past 17 years. The estimate continues to fall in 2018 at $410;
  • Rising interest rates are likely dishing up strong disincentives for homeowners to sell their current homes, placing downward pressure on the inventory of homes for sale and pressuring the trade-up markets across the country. Interest rates for 30-year benchmark mortgages have been below 5% since early 2011which means virtually everyone that financed their purchases in the last six years has locked in some of the lowest rates since WWII. Trading up market entails swapping out an historically low mortgage for a new higher rate loan. The economics should spur more homeowners toward home improvement projects than entering the homebuying market, possibly bringing Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) into play;
  • As interest rates rise, affordability becomes an increasing headwind. Wage growth for nonfarm payrolls through the end of December hit 2.93%, the strongest post since 2009, providing the best signal to date of a constricting labor force that is pressuring employers in markets across the country to increase wage and benefit packages. Still, home price growth remains almost twice that of wage growth through October posted by the 20-city composite S&P Case Shiller Home Price Index. For surging markets like Seattle, Portland and Denver, spread between wage growth and home prices in these markets is even more pronounced at 3.65 times, 3.53 times and 2.82 times, respectively;
  • Residential investment has declined in each of the last two consecutive quarters, falling 7.4% in the 3rd quarter and 4.2% in the 4th quarter;
  • Household formation, affordability and income are closely related. Among in the age group 25 to 34, about 40% of those earning less than $25,000 headed their own household. The share rose to $50 for those earning between $25,000 and $50,000 and hit 58% for those with incomes over $50,000, according to data from the Harvard Joint Center for Housing Studies. Today, almost 40% of that age group still live with parents, siblings or other relatives through the end of 2015, which further complicates the trade-up market as first time buyers are further squeezed out of the market;
  • On average, US banking stocks have soared since the election. Likewise, the 30-year mortgage rate has soared from 3.36% to 4.32% through the end of the year, moderating somewhat in the first week of January to 4.20%.

Figure 1: Financial Summary

S&P

NVR

KBH

LEN

PHM

DHI

P/E (TTM)

20.7

16.13

14

11.33

11.60

11.66

EPS

23.28

98.05

1.15

3.79

1.60

2.36

Price/Book

2.98

4.61

0.81

1.49

1.32

1.51

Price/Cashflow

13.93

11.75

9.48

10.03

10.85

Gross Margin

19.58

16.44

13.64

22.59

21.93

ROE

32.16

6.72

14.63

11.98

13.97

ROA

15.60

2.25

6.14

5.97

7.81

Market Cap (B)

5.993

1.359

8.948

6.118

10.274

Source: Reuters, FactSet, Standard & Poor

How have the stock prices of home builders fared? DR Horton (NYSE:DHI), NVR (NYSE:NVR), Pulte Group (NYSE:PHM), Lennar Corporation (NYSE:LEN) and KB Home (NYSE:KBH) are largely representative of the homebuilding industry as a whole. Outside of NVR, whose operations are mainly on the east coast, most of the companies have stakes in most of the geographic regions of the country. DR Horton is the largest by market capitalization at $10.274 billion while KB Homes is the smallest by the same measure at $1.359 billion. NVR has the highest PE ratio of the group but still falls well below that of the S&P 500. Outside of KBH, Len, PHM and DHI carry PE ratios that are less than half that of the S&P. NVR holds the highest earnings per share by a factor of four over S&P companies as a whole and almost 26 times that of LEN due primarily to NVR's low relative float. Still, NVR's price-to-book value is about 55% higher than that of S&P companies and just over three times that of DHI. From a total return perspective, NVR ended the year up 1.58%. By way of contrast, KBH posted the weakest underlying fundamentals for the year but managed a market gain of 28.22% for the year. PHM was up 3.14% while both DHI and LEN fell sharply for the year at -14.67% and -12.23%, respectively.

Arguably, prevailing interest rates during the course of 2016 provided a determining factor in the performance of each, underscoring just how dependent the homebuilding industry is on homebuyers being able to finance their purchases.

The 10-year Treasury note started 2016 at a yield of 2.169%. By the second week in February, the yield on the 10-year benchmark had fallen to 1.61%, as market expectations braced for the first of four hikes in the federal funds rate projected by the FOMC in its December 2015 meeting, the second hike widely expected to be announced at the FOMC meeting in March. Each of the homebuilders in the sample hit corresponding market lows during this early February period. By the first week in July the yield on the 10-year Treasury note had plummeted to a new historic low of 1.336% as global markets were forced quickly to price in the stunning results of the Brexit referendum. Each of the companies in the sample reached year-to-date market highs during the first weeks of July. National home prices continued to grow at a monthly rate of 5% or better from July through October. As the yield on the 10-year Treasury note began to edge up from its year-to-date trough of 1.366% in the first week of July to the eve of the election, the yield on the 10-year benchmark had climbed to 1.82%.

NVR fell sharply from its July high of $1,830 on the 8th of July, plunging to its low for the year just days before the election at $1,503.18 for an 18% move in a 4-month period before staging a comeback of just over 9% to end the year to scratch out a small but positive gain for the year.

DHI hit a market high of $50.46 on the 20th of July before plunging to $29.37 on the eve of the election for almost a 42% slide in market value. The stock would fall even further before making up some of its losses but remain solidly in the red by the end of the year.

PHM followed the same pattern hitting its year high of $53.32 toward the end of July, falling to $18.60 on the 7th of November for a 16% drop for the period. By the 8th of December the stock has clawed back some of its losses with a spike to $19.85 only to slide through the rest of the year to end up with a gain for the year of just over 3%.

LEN peaked for the year in early July at a price of $49.16 only to slide to a market price of $41.94% by the first week of November for a 15% decline. LEN staged a small gain through the market close of 8 December to a post of $45.67 which was far short of turning the year black, posting a 12% loss for the period.

KBH did not follow the paradigm. While still peaking for the year in the latter part of July at $16.62 as the 10-year Treasury note hit an all-time low, KBH remained positive for the year at its 7 November post of $14.65 for a loss of almost 12% from its high - but still up almost 46% on the start of the year. The spurt in the first week of December sent the stock to a new year high of $17.21 before shedding some of its gains to finish at a gain of 22% on the year. Given the mixed results of the sample, KBH is attracting a good deal of short interest-three times that of its nearest competitor, PHM, through the end of the year.

Interest rates will continue to adjust in 2017 and will correlate closely to Mr. Trump's perceived ability to deliver on his spending plans for the economy. As Mr. Trump waits to take his oath of office, a quick step back in time to 1981 when another political outsider won the presidency is likely helpful. Ronald Reagan took office just after a second international oil crisis had sent the US economy into a recession. Unemployment was high. When oil prices collapsed and inflation was finally corralled, the seeds of one of the longest bull market in history were largely sowed.

In contrast, Mr. Trump steps to the plate in an inflation environment that is one of the lowest in the post-WWII era. Employment is close to the natural level of full employment in spite of a mixed and uneven recovery to date. The demographics of an aging work force, a low national birth rate and the gains of the first entrance of women into the workforce long past, coupled with years of weak capital investment, rapid economic growth from the fiscal side faces an array of structural headwinds - least of which being sustainability. US debt as a percentage of GDP is now just over 100%. Corporate debt, ballooned by financing years of buyback, enhanced dividend programs and M&A activity, is at historic levels. Rising borrowing costs could severely crimp corporate's ability to both invest and services its outstanding debt simultaneously. The Republican bench in Congress is still deep with fiscal conservatives and deficit hawks that will likely continue to dig in their collective heels in the face of deficit spending.

Homebuilders will likely struggle in 2017 and beyond.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.