Investors are betting on a housing recovery. Is their optimism misplaced?
US home-building stocks have bounced back over the past four months, suggesting that investors are looking beyond interest rate hikes and soaring borrowing costs even as the Federal Reserve raised its key rate again on Wednesday.
The SPDR S&P home builders ETF, an exchange-traded fund that tracks stocks such as DR Horton Inc. At DHI, PulteGroup Inc. PHM-N and Lennar Corp. LEN-N has risen 17 percent so far this year, easily outperforming the S&P 500.
The ETF, which also includes home-related stocks like Williams-Sonoma Inc. WSM-N and Home Depot Inc. HD-N, is up 33 percent since mid-October. The gains contrast with the US housing market, which has faced challenges over the past year.
In its battle against surging inflation, the Fed has raised its key interest rate eight times since March, 2022, from a low of near zero to a range between 4.5 percent and 4.75 percent on Wednesday.
The increases have sent mortgage rates to multiyear highs and hampered prospective homebuyers.
According to the Federal Home Loan Mortgage Corporation, or Freddie Mac, the average 30-year mortgage rate rose above 7 percent in October, a 20-year high and up from 3.55 percent at the start of 2022.
That has weighed on housing affordability to the point where just 42 percent of home sales are currently affordable to a typical household – the lowest affordability reading since the Great Recession in 2008-09, according to the National Association of Realtors.
Not surprisingly, home-building activity has also suffered. US housing starts, or the number of new homes under construction, fell sharply in 2022. By December, starts were down 21.8 percent compared with December, 2021.
The decline has sent a chill through the home-building industry. Builder confidence, tracked by a sentiment survey from the National Association of Realtors, fell to a decade low in December (not including a brief dip in early 2020, during the start of the pandemic).
With this sort of ugly backdrop, why have investors jumped into home-building stocks?
The quick answer is that the US housing market has begun to look less-bad on some measures, giving risk-takers a strong incentive to buy beaten-up stocks during a low point in sentiment in the hope that better days are coming.
“Home builder stocks tend to bottom as mortgage rates peak,” Rafe Jadrosich, an analyst at Bank of America, said in a note in mid-January.
His bullish case: Low stock valuations are at recessionary levels and already reflecting weak demand; mortgage rates have declined from their recent highs and should move lower in 2023; and lower input costs, especially from cheaper lumber, should bolster builder margins.
Housing economists also sound increasingly optimistic that the worst may be over for the housing market, which could be good news for Canadian lumber producers, such as West Fraser Timber Co. Ltd. WFG-T, as well.
“The upcoming months should see a return of buyers, as mortgage rates appear to have already peaked and have been coming down since mid-November,” Lawrence Yun, chief economist at the National Association of Realtors, tweeted on Wednesday.
Similarly, Robert Dietz, chief economist of the National Association of Home Builders, expects the Fed will end rate hikes in March, cooling mortgage rates and setting up a turning point for the economy in the second half of 2023.
“The pace of single-family construction will bottom out in the first half of 2023 and begin to improve in the latter part of the year,” Mr. Dietz said in his remarks on Tuesday at the 2023 International Builders’ Show.
That could be good news for investors joining the rally in home-builder stocks well after it began.
There are a lot of moving parts here, though, including whether economic activity falls more than expected and unemployment accelerates as higher interest rates dig in. Stocks like Lennar and PulteGroup are now just 5 percent or so below their recent highs in 2021, suggesting that a lot of optimism is already priced in.
Investors are betting on a housing rebound. But with a whiff of bad news, the recent rally could turn choppy.