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Update On The Homebuilders

|Includes: Beazer Homes USA, Inc. (BZH), CAA, DHI, HOV, KBH, LEN, MDC, MHO, MTH, NVR, PHM, RYL, TOL

The Lark Research Homebuilder Stock Price Index, an equal-weighted, weekly average of stock price performance for 13 large, publicly-traded homebuilders, registered a gain of 5.60% in the week ended October 25, 2013. By comparison, the S&P 500 was up 0.88% and the Russell 2000 was up 0.32%. The home construction group was the third best performing of the 96 sectors included in the Dow Jones U.S. Total Market Index last week.

The strong performance was driven mostly by the builders that reported earnings last week. (MHO +12.6%, PHM +8.8%, MTH +6.9) Other big gainers included RYL (+9.3%) and SPF (+6.4%), both of which report this week.

The group's better-than-average gains were driven by better-than-expected earnings results, upbeat outlooks given by the CEOs of the companies that reported and further declines in mortgage rates.

So far, for the six homebuilders that have reported this earnings season, actual (adjusted) earnings are up nearly three-fold on average from prior year levels. The average builder has exceeded the mean estimate of analysts by about 23%.

Builders exceeded earnings expectations as a result of stronger-than-anticipated unit sales and average prices and higher-than-anticipated operating margins. Most builders acknowledged that rising house prices and mortgage rates and, more recently, the turmoil in Washington, have taken some of the steam out of the market. This is reflected in average growth of only 1% in unit orders. They also report that supply remains tight, so they still have some pricing power. Most builders have also shifted their product offerings to target more move-up buyers, the segment of the market where demand has remained strong.

At the current levels, the group is trading at roughly 19-20 times projected 2013 earnings and at about 14 times projected 2014 earnings. Although this is higher than pre-crisis norms, the group's forward multiples have come down significantly in 2013. At the beginning of the year, rising stock prices drove forward multiples as high as 30 times projected 2013 earnings and about 20 times projected 2014 earnings. During the course of the year, however, earnings estimates have come up sharply and so forward multiples have come down. Since the housing market should still be in the early stages of recovery, the current forward multiples are reasonable. Homebuilder stocks should still have upside from current levels, assuming that the housing recovery lasts for a few more years.

Even so, the housing market will probably suffer some bumps along the road. Although there appears to be enough pent-up demand to sustain the move-up market for awhile, the recovery in housing will be increasingly restrained if the participation of first-time buyers continues to be below historical averages. Higher house prices and interest rates have reduced affordability, especially for first-time buyers. The rise in interest rates has also contributed to the slowing in the rate of job formation, which slows the growth in the pool of potential first-time buyers. Some states have already acted to encourage greater participation from first-time buyers by offering low-rate mortgages. Such efforts might sometime be expanded at the Federal level, but it is not clear whether they would be wise moves in the long-run, since they usually reduce future demand and often raise default risk.

In the meantime, mortgage rates have come down over the past few weeks. According to Freddie Mac's Weekly Mortgage Survey, the rate on the 30-year fixed rate mortgage has fallen from a peak of 4.58% on August 22 to 4.13% on October 27. Most of the decline has occurred during the month of October, after the Fed said that it would delay the start of the tapering of its Quantitative Easing program. Mortgage rates may fall further, if the 10-year Treasury yield continues to decline, but they will probably not return to the historic lows of around 3.40% of last Spring, unless the momentum of the economic recovery weakens more. In that case, the benefit of lower mortgage rates may be offset by a weaker economic outlook, including a lower rate of job formation.

From an investment perspective, Toll Brothers (NYSE:TOL) has been a long-term holding of the Income Builder model equity portfolio. In mid-August, in anticipation that homebuilder stocks were nearing the end of their correction, I added to the portfolio's homebuilder exposure, with small positions in Hovnanian Enterprises (NYSE:HOV), KB Home (NYSE:KBH) and M/I Homes (NYSE:MHO).

At this point, assuming that the U.S. economic recovery eventually speeds up, homebuilder stocks will most likely reach new highs within the next year or so. Despite the group's relatively strong performance last week, however, these stocks may retest their recent lows, if the stock market's overall momentum continues to slow. The homebuilders have outperformed the broader market since the late August bottom. If, as I anticipate, they show further signs of stabilization (even as the broader market suffers a modest correction), I intend to add to my exposure.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BZH, DHI, HOV, KBH, LEN, MDC, MHO, MTH, NVR, PHM, RYL, SPF, TOL over the next 72 hours.