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Home Builders At A Crossroads (Again)

|Includes: DHI, ITB, Lennar Corporation (LEN), PHM, TOL, XHB

While most sectors are suffering a news drought headed into the Christmas and New Year's holidays, it has been a relatively busy week of data for the housing market. Information on existing home sales, new home sales, mortgage rates and earnings from a major home builder are all out this week.

The data rush returns the spotlight to the housing sector, which was one of the bright spots of the economy in 2016. It also raises questions about the home building space, which followed an uncertain 2015 with a bumpy 2016. Now, with 2017 about to start, the question remains: are the recent swings for the home building sector likely to continue?

The question comes as two of the most prominent home builders are set to announce their quarterly results next month.

The housing numbers have generally pointed to overall market strength over the past year (backed up by another strong release on Wednesday). However, trading in the home building sector has been choppy throughout 2016, following up on a similarly volatile 2015. Meanwhile, market conditions headed into 2017 have left the near-term future for the sector open to debate.

In recent trading, the stocks most affected by the home building sector saw a strong rally in November and into the first week of December. But the sector has seen some profit taking lately.

Looking longer term, in 2015, the home building sector also finished the year strong (though off its summer highs) only to suffer a major swoon early in 2016 amid uncertainty about the economy in general and about the industry in particular. These worries turned out to be unfounded and data gathered showing a strong housing market. By the summer, bolstered by the positive data, the home building sector recovered all the ground it lost earlier in the year.

The momentum lost steam, however, as the sector remained off multi-year highs reached in 2015. There was another fall off in the autumn, followed by the recovery in November and early December.

The sector is now basically where it was at the end of 2015, both in terms of its trading levels and in terms of questions about the sustainability of recent strength in the market. The underlying supply-demand picture for the market looks good. But higher interest rates could affect the affordability of homes, and the prospects of increased immigration scrutiny could affect the workforce for home construction.

The latest report provided another positive data point for the housing sector. On Wednesday, the National Association of Realtors released its figures on existing home sales, a measure of sales of previously owned homes. The NAR said sales climbed 0.7% in November, surprising economists, who had predicted that the figure would suffer a dip. This followed a previous unexpected jump in sales in October.

But Wednesday also saw a sign of caution about the possibility of sustaining sales growth. A second report released during the day showed that 30-year mortgage rates have reached their highest level in more than two years. The Mortgage Bankers Association said the average 30-year fixed-rate mortgage climbed to 4.41 percent for the latest week. This was the highest level since May 2014.

Along with the economic data, this week has also seen an earnings release from a major home builder, Lennar ($LEN), which saw its profit rise on higher deliveries and higher prices. LEN initially rallied on the news, jumping higher at the open immediately after the earnings release. There was no follow through on the initial advance, however, and by mid-morning, the stock had given back most of its gains. It eventually finished the day fractionally lower.

In the lead up to its earnings release, implied volatility for LEN reached 30.2, moving just above a multi-month range to reach its highest level since March.

The existing home sales results and the earnings from Lennar will be followed up on Thursday by the government's figures on new home sales. These figures represent a smaller part of the housing market, but more closely track the home building sector.

Last month's figures showed a drop in new home sales. A report issued by the U.S. Commerce Department showed new home sales fell by 1.9 percent in October. Economists had predicted a fall, but the decline was more pronounced then they had expected.

However, even with the decline compared to the previous month, new home sales were up 17.8 percent compared to last year. The rate of new home sales reached a multi-year high back in July. However, they have lost ground since then, perhaps hurt by the prospect of higher interest rates.

So what instruments should you use to track the home building sector?

There are two main home building ETFs that can be used. There is the $ITB, the iShares U.S. Home Construction ETF, and there is the $XHB, which is the SPDR Homebuilders ETF. There are other, smaller possibilities, but those are the most prominent options.

Both the ITB and XHB have showed relatively subdued levels of implied volatility lately. The ITB reached 26.8 on November 4, its highest level since June, while the XHB reached a similar high of 25.6 on the same day. The ITB is currently at 17.9, at the low end of a 3-month range, while the XHB is at 18.6, toward the middle of a narrow multi-week range.

Another method of attacking the home building space would be to choose individual names in the space. While Lennar has already released its quarterly results, and Toll Brothers ($TOL) announced results earlier this month, there are a couple of big home builders that are slated to announce their figures next month.

DR Horton ($DHI), which holds the biggest market share among publicly traded U.S. home builders, is set to announce its quarterly results on January 24, 2017. Implied volatility is low for DHI, holding in a range since late November and currently sitting around 26.4. IV had reached 36.3 on November 4 going into its last earnings report, its highest mark since February.

PulteGroup ($PHM) is expected to report on Jan 26, 2017. Implied volatility for the stock has been holding in a range lately. However, ahead of its last earnings announcement in October, IV for PHM climbed notably, reaching a peak on October 13 of 38.1 - its highest level since February. For the January 27 expiration, which should include the company's next earnings release, the current ATM Straddle premium is $1.49, or 7.8%. For the February 17 expiration, it is $1.84, or 9.6%.

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