Seeking Alpha

Building Permits Jump, But Don't Get Too Excited

by: Leo Nelissen

Homebuilders continued their rally in September and are up 40% year to date.

Just released housing data shows that building permits are up big.

Housing market strength was desperately needed as traders were already pricing in huge gains.

Going forward, we will see if building permits can continue to remain strong despite the headwinds from much slower economic growth.

Homebuilders continue to be one of the most interesting bunch of stocks on the market. The iShares Trust US Home Construction ETF (ITB) is one of the strongest performers year to date despite weak building permits and a slowing economy. It seemed that traders were rushing to cyclical homebuilders as a result of a weakness caused by bond price rally. The just released data shows that both building permits and housing starts went through the roof. Still, we are dealing with a very common phenomenon that does not mean that things are getting better. I am sticking to my approach even though I have to admit to making one major mistake. Bear with me!

Source: BONE Structure

What Happened?

The most important thing to remember with regard to the current situation is that homebuilders did very poorly in the second half of 2018. Back then, the US economy was in a somewhat unique situation as both Asia and Europe peaked in the first quarter of 2018. US economic growth peaked a few months later in Q4 of the same year. Homebuilding stocks got sold off pretty heavily at the end of 2018 losing almost 20% on a year-on-year basis. Interestingly enough, building permits have been in contraction since then - until now.

In my most recent article called 'Homebuilders: Make Or Break', I discussed that either homebuilding stocks had to drop significantly or building permits had to get a massive boost to justify the 40% year-to-date performance. I made one mistake which I will explain in this article.

Anyhow, what we got was indeed a massive building permits boost as you probably already saw in the graph above. August building permits reached a new multi-year high and were up 12.0% year on year. In other words, building permits went from a very long period of contraction to one of the highest growth rates since 2013. The more volatile housing starts were up 6.7% and even 1-unit building permits were up 4.5%. In other words, it's fair to say that the entire housing market is seeing strength.

The leading NAHB housing market index, which tracks single-family housing sentiment, improved to 68 in September from 67 in August. Note that the August number has been revised from 66 to 67. In other words, NAHB sentiment is also up on a year-on-year basis. In this case, the growth rate is at 1.5%. It's supporting higher building permits, but not an extended rally like we are currently seeing.

With that said, let's discuss my mistake. First of all, I have been on the sidelines for the biggest part of the current housing upswing. The reason is because the rally was dependent on a massive building permits rebound like we are currently seeing. I did not want to take that risk as the general economy is getting pretty bad as well as I discussed in this article.

It just did not make too much sense to buy homebuilders simply because rates were down. I already owned bonds, so why add significant risk by buying cyclical homebuilders? Well, the answer is simple: it has worked in the past.

The graph below shows the year-on-year performance of building permits (1-unit and total) and the year-on-year performance of the 10-year bond. Every time bond yields significantly drop, building permits start to rebound just a few months later. Also, every time rates spike, building permits start to contract just a few months later. Regardless whether the economy is in a recession or not.

In other words, when rates started to drop, it was almost a certainty that building permits were about to rebound. And as both building permits and housing stocks were down big a few months ago, it made sense to start buying.

That said, we are now at a point where the effect of very low rates has already worked, while the economy continues to slow. I expect that a lot of growth is already priced in at this point and further building permits strength is needed to push the ITB ETF to new highs.

Source: FINVIZ

I still won't be buying building stocks, but I learned a valuable lesson. (Almost) all cyclical stocks on my radar I avoided did poorly except for homebuilders. I continue to stick to cash as I dislike the current risk/reward of homebuilders. Moreover, I am currently working on an article discussing a housing ETF I like as a long-term investment as it reduces some of the risks the ITB ETF has. Nonetheless, ITB remains the go-to ETF to track homebuilders as it eliminates the need to own single homebuilding stocks. Hence, the ITB ETF will remain one of my key trading tools.

Stay tuned!

Thank you very much for reading my article. Feel free to click on the "Like" button and don't forget to share your opinion in the comment section down below!

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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.