Economics & Growth | Equities | US
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Pop quiz time: when was the stock bubble of our lifetime? If you said homebuilders during 2005-6 (Chart 1), congratulations!
Chart 1: The Tech Bubble Was Big but Homebuilders Was Even Bigger
Source: Yahoo Finance, FRED, Bloomberg Finance LP
Following that period, homebuilders crashed, hitting bottom during 4Q 2008. Since then, the sector has had its ups and downs versus the broader S&P 500 (Chart 2), and of course it has lagged far behind the tech sector. So there’s much to prompt caution over homebuilders, but the economic outlook might suggest otherwise.
Builder Sentiment Is Near All-Time Highs
Over the past two years homebuilder equities have ridden a rollercoaster. A homebuilder ETF (XHB) that tracks the S&P Homebuilders Index underperformed the S&P 500 by nearly 22% in 2018; so far in 2019, it is outperforming by 17% (Chart 2). Homebuilder sentiment is about 68 (where 50 is the dividing line between improving and deteriorating expectations), which is near its lifetime high (Chart 3).
Chart 2: Are Homebuilder Prospects Looking Up?
Chart 3: Builder Sentiment Is Outrunning Housing Starts
Source: Yahoo Finance, FRED, Bloomberg Finance LP
There’s a small problem here. Historically, builder sentiment has closely tracked housing starts (and related construction activity). Over the past few years, however, housing activity has failed to keep pace with builders’ rising animal spirits. Note also that when builder sentiment has climbed too far ahead of housing fundamentals in the past, this has signalled not a forthcoming boom but rather that expectations are eventually due to return to earth. But will it be different now?
Mortgage Rates and GDP Drive Homebuilder Stocks
To better understand the macro factors potentially driving homebuilder stocks relative to the S&P 500 (represented here by the S&P 500 ETF SPY), we ran a regression model for the 2007-present and 2012-present periods. We regressed quarterly changes in the XHB/SPY return ratio on quarterly changes on five variables (Table 1, below).
Table 1: Regression Statistics – Quarterly Change Model
For both periods, all variables are statistically significant except housing starts – perhaps unsurprising in light of Chart 3 above. Interestingly, the most significant variables are the 30-year mortgage rate and real GDP, both with negative coefficients, implying homebuilder stocks rise as these variables decline and vice versa. That makes sense for mortgage rates: homebuilder stocks are highly sensitive to changes in mortgage rates (Charts 4a and b).
The relationship with GDP may be less intuitive, but recall that the dependent variable is the relative performance of homebuilders to the S&P 500. When the broader economy strengthens, more companies outperform homebuilders.
Note also that homebuilder sentiment has a positive and highly significant coefficient. Apparently, when homebuilders get bulled up, investors listen up.
Chart 4: Sentiment Surges When Rates Drop
Chart 5: … Especially As Mtg Rates Fall Below 4%
Source: Macro Hive, Bloomberg LLP
(We tried other housing-related variables such as pending home sales, existing home sales, and the Mortgage Bankers Association mortgage purchase and refinancing index, but the variables in the table above generated more robust results.)
The regression model residuals suggest that homebuilders are rich relative to the broader market, particularly for the more recent period (Chart 5, below). The standardized residual has been between 1.5 and 2 recently, which is near the high for the series.
Chart 6: Residuals Imply Homebuilders Are Rich
Source: Yahoo Finance, FRED
Time to Sell Or Buy Homebuilders?
Homebuilders have rallied in 2019 due to falling mortgage rates, a slowing GDP, and robust builder sentiment. Even considering that support, however, valuations seem to have run ahead of themselves. And housing fundamentals, while gradually improving, also remain sluggish by historical standards (Chart 3) with no indication that another housing boom is taking root.
All that said, there is good indication that the coming months and even quarters could be a Goldilocks period for homebuilders. If the US GDP remains stuck below 2% but still in growth mode, and mortgage rates remain near present levels or keep trending down (both of which are likely), the homebuilder sector could reasonably be expected to perform in line with the market or continue to outperform.
For homebuilders to underperform, mortgage rates (now around 3.75%) would have to rise above 4% or GDP growth would need to pick up substantially. The other scenario is a collapse into recession for some reason. This would hit most stocks, but if 2008-9 is in any indication, homebuilders will perform far worse than the broader market.
For now, we see merit in looking past more technical indicators of homebuilder equity performance (as evidenced by the regression residuals and soaring builder sentiment). We would add to homebuilder positions if it becomes apparent that the Goldilocks scenario is indeed developing.
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.)