Homebuilder stock prices went on much the same roller coaster ride as the broader market earlier in the month of October, falling sharply through support and then climbing back just as quickly to avoid serious technical damage.
The Lark Research Homebuilder Stock Price Index fell 10.6% from September 19 to October 10, much worse than the declines of 5.2% and 8.2% in the S&P 500 and Russell 2000. During the two week period from October 10 to October 24, the homebuilders rallied back 12.6%, also better than the advances of 3.1% in the S&P 500 and 6.2% in the Russell. Last week, homebuilder stocks fell 2.2%, while the broader averages extended their gains.
From the end of 2011 until April 2013, homebuilder shares rallied sharply, right up until the taper tantrum, due to optimism about the recovery in housing. Since then, the stocks have traded sideways, forming a flag pattern, which is characterized by increasing tension as the price converges to the tip of the flag, often resolved with an upside breakout.
In October, the Index clearly broke through the bottom trendline of the flag, raising concerns that homebuilder stocks could go lower (and possibly much lower), but the stocks rallied back with the market and are now comfortably within the flag. At this point, I calculate that the average homebuilder stock is 2% below its 50-day moving average but 3% above its 200-day moving average.
The sideways trading pattern presaged slowing upward momentum in housing production. With the steady, but tepid, growth in the economy and rise in employment in 2012 and 2013, buyers came off the sidelines, unleashing a modest amount of pent-up demand. Single-family housing starts increased from 430,000 units in 2011 to nearly 620,000 units in 2013, an average annual gain of 20%. That looks impressive, but coming off of generational lows, such a strong rebound was not entirely unexpected.
Surprisingly, however, the lift off the bottom was accompanied by a sharp increase in house prices. Despite a still large number of vacant homes, the average price of a new home rose 9% in 2012 and 11% in 2013. Most of these vacant homes have been held off market, so available inventories were actually quite lean. The steady reduction in distressed home sales helped cleared the way for the sharp rebound in pricing. Although this was good news for sellers (and homebuilders), the rise in average prices combined with still tight underwriting guidelines pushed many potential buyers back to the sidelines. No surprise then that housing production has flattened out in 2014 along with homebuilder stock prices.
The sideways trading pattern reflects uncertainty about the likely direction of home sales (and homebuilder profits). Severe winter weather-driven weakness in housing and the economy in the 2014 first quarter wrecked what should have been a decent spring selling season. Many buyers are still fearful about the direction of the economy and the security of their jobs, but the steady improvement in both over the past few months has raised confidence levels. Mortgage underwriting standards are still a constraint, especially for first-time homebuyers, but the government moved recently to allow Fannie Mae and Freddie Mac to purchase mortgages on houses with downpayments as low as 3%. That along with the elimination of the risk retention requirement for mortgage securitizers should improve mortgage financing availability. In the short-term, this should help boost housing sales. In the longer term, it remains to be seen whether this results in the same excesses that led to the collapse of the housing market in 2007.
While the decisions on qualified mortgages may have helped lift homebuilder shares in recent weeks, there is still some uncertainty about the current and future performance of the homebuilders. Third quarter earnings have not been great. Although the earnings of one or two builders - Lennar, for example - surprised on the upside, a greater number of builders missed on both earnings and revenues. Yet, all of the builders remain upbeat. In many cases, builders attributed the shortfalls to delays in production or mortgage approvals. Orders remain decent. Backlogs are high. Most builders see improving performance in 2015.
This expected improvement is already baked into analysts' 2015 estimates. The average analyst estimate for 2015 for eleven large builders anticipates average earnings growth of 22%. Yet, the average forward earnings multiple (for 2015) for the group is around 12, well below the market average and a sign that investors remain skeptical about whether the builders can deliver.
As long as geopolitical risks remain at bay, however, the economy should continue to grow at around a 3% and add 200,000 jobs per month. Combined with the loosening of mortgage underwriters' purse strings, this should help the builders meet analysts' targets. If so, homebuilder stocks are clearly cheap. It is hard to imagine that the stock market can move meaningfully higher from here without further improvement in the housing sector and greater participation from homebuilder stocks.