Equity Strategy: Shift Homebuilders to Underweight

Summary

• We remain cautious on equities as 2Q earnings season nears the end.
• We have only one change this week – move homebuilders from marketweight to underweight. We view this as a tactical rather than fundamental move.
• There has been an astonishingly rapid increase in completed new homes available for sale, to 6.2 months’ supply in June. Even during the worst of the 2008-09 housing crash this measure only reached 4.7 months’ supply.
• Existing homes inventories remain near record lows, so homebuilders may be able to work off excess inventory fairly quickly.

Market Implications

• Homebuilders will surely hit the brakes on new projects until they work off this excess inventory, which will hurt 2H revenue and earnings.
• As inventories correct, we anticipate upgrading homebuilders to market- or over-weight.

Earnings Season Ends With a Good Tone

About 90% of companies have now reported 2Q earnings, for an average beat of 4.1%. The surprise for us was how few companies warned of potential weakness during 2H. Many companies acknowledged rising risks of recession, but viewed it as still low, and further in the future.

We also note that those companies reporting weaker than expected results or outlooks also tended to experience sharp selloffs – a sign that equity market investors appear constructive about the outlook for now.

It is not unusual for equities to develop a tailwind during a good or decent earnings season. Going forward the focus will shift from company specifics to broader macro concerns and Fed policy. We expect equities to settle into a range or weaken in coming weeks.

Homebuilders Move to a Tactical Underweight

We have been advocates of homebuilders this year, largely because the industry is not what it was in 1990 or 2008 when the housing market collapsed. Nevertheless, the sudden rise in mortgage rates from 2.8% in early 2022 to 5.5% recently has been an enormous shock to the housing market.

In particular, there has been an astounding jump in new homes available for sale, up 17.5% in 2022 (Chart 1).  On a month’s supply basis, houses available for sale stands at 9.1 months – near recession levels. Supply of completed homes jumped to 6.2 months, versus 3.8 months in December 2021. Even during the worst of the 2008-09 housing collapse completed homes only reached 4.7 months’ supply.

This spike in new homes available for sale surely reflects cancelations to a large degree. As mortgage rates spiralled from 2.8% to 5.5% in a matter of just a few months, would-be buyers have found themselves unable to afford or qualify for a mortgage. The National Association of Realtors index of housing affordability is now near 100; during 4Q 2021 it was near 150.^[1]

Our expectation is that homebuilders will slow or halt further construction plans until this inventory is worked off. That implies that revenue and earnings during 2H will be depressed, with likely consequences for homebuilder equities.

It is Not All Bad News

If there is a silver lining here, it is that existing home inventory remains near record lows (Chart 2). This is in sharp contrast to 2008 when new and existing home inventories rose in tandem. People still looking to buy homes may find homebuilders willing to deal to work off excess inventory.

We view this as a tactical underweight. Assuming new home inventories return to more normal levels in coming months we expect to move homebuilders to market- or over-weight. Housing is going through a painful adjustment now, but the overall supply of housing in the US remains tight. As homebuilders adjust supply (and pricing) to ongoing demand they should be able to make money in this environment.

[1] The NAR housing affordability index is a measure of the median income household ability to afford a mortgage on the median priced house. A value of 1500 means the median income household has 150% of the income required to cover a mortgage on the median priced house.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)