If you had the good fortune to pick up some housing stocks in the middle of 2000, you would have doubled your money in a year. But don't kick yourself if you missed that move. Since its peak in July 2001, the S&P Housing Index has dropped 20%. That hardly qualifies as a major correction in this market, but it's certainly enough to make valuations more appealing again.
There's a good reason to look at these stocks, even though they may trade down soon on negative news in the housing market.
A downturn in the housing cycle doesn't spell disaster for all housing stocks. The industry is in relatively good shape compared with the last recession, and the top companies are well-positioned in markets that have pockets of strength. Plus, the stocks are already selling at near recession levels, and that should help limit the downside.
Nevertheless, keep an eye out for bad news on the economy in the next few weeks that could have a negative effect on housing stocks. "Most fund managers don't want to step in front of these names with the economy weakening. The unemployment rate has ticked up to 5.4% in a very short time, so the implications for housing aren't great with that," says Philip Laverson, who covers the sector for the Merrill Lynch large-cap series of funds, which is overweighted in housing names relative to its peer group.
And with all the conflicting data out in the market, there will be jitters. Stephen Kim, homebuilding analyst at Salomon Smith Barney, told me the conversations he's had with investors about housing stocks have been characterized by "a lot of head-scratching and beard-stroking." Though it may seem inevitable that widespread layoffs and plunging consumer confidence will catch up with the housing market at some point, there are plenty of reasons why housing could remain surprisingly resilient this cycle.
Here's why housing may not collapse:
- Housing is getting more affordable by the day. Mortgage rates have hit 30-year lows, with the average contract interest rate for a 30-year fixed-rate mortgage falling below 6.5%, compared with the 10% rates that prevailed in the last recession. On Nov. 6 the
Federal Reserve cut interest rates another one-half percentage point, and many on Wall Street think another half-point cut is possible by January, increasing the likelihood that mortgage rates will fall further, along with other bond yields such as the 10-year Treasury. The 10-year Treasury yield and housing stocks have demonstrated a very tight inverse correlation, as shown in the chart below.
Homebuilders vs. the 10-Year Treasury Yield
- There are already signs that the lower rates are boosting new homebuying activity. The weekly mortgage purchase index, a measure of loan purchases released by homebuyers as measured by the Mortgage Bankers Association of America, increased slightly for the week ending Oct. 26. This is a key indicator that is released weekly on the organization's
Despite fears that we've had a speculative real estate bubble mirroring the stock market, home values are stubbornly firm, making consumers more willing to commit. The National Association of Realtors still expects home prices this year to post increases that "are faster than historic norms," which it pegs at one to two points higher than inflation, as measured by the CPI, according to a recent press release. Homes still represent a significant 24% of personal assets, so as long as housing prices continue to rise, and people can "expect to get value out of their homes," they're more inclined to close the deal, says Celia Chen, senior economist at Economy.com.
But cracks that formed in the foundation of the housing sector before the Sept. 11 attacks turned into fissures afterwards. Here's the bad news to keep an eye on.
- The housing market weakened in September, with existing home sales plunging 11.7% for the month. The number for October could also be weak, and should come out right after Thanksgiving.
Income growth is weakening, compromising people's ability to make big purchases. Real disposable income (DPI) growth declined 1.5% from August to September, after a big growth surge in July and August caused by tax refunds. This caused third-quarter real DPI to jump 11.6%, annualized. Chen expects fourth-quarter real DPI growth to increase at a 3.5% rate and slow to just 0.3% by the middle of next year.
The consumer isn't in great shape to begin with. The consumer debt-service burden, which measures things such as monthly mortgage, credit card and loan payments as a percentage of disposable personal income, is up to 14%, close to its last peak of 14.2% in 1987.
Consumer confidence, a key housing indicator, plunged after Sept. 11 and could fall further. November's consumer confidence numbers should also be released the week after Thanksgiving. "If you don't think you're going to have a job, or you're worried about the political outlook, you would be cautious about purchasing a home. The downside risk is consumer confidence. If the war in Afghanistan isn't resolved soon or there were another terrorist attack, that would further weaken confidence that is already very weak," says Chen.
But if any of this negative news weighs on the stocks, I'd be a buyer for these reasons:
- Compared with the last housing downturn in the 1990-1991 recession, the industry overall and the companies in it appear to be much better off. For example, there doesn't appear to be a glut of new homes sitting unsold in the market. In fact, new home inventory is at a near-historic low of just 3.6 months supply -- less than half the level in the market during the last recession. "It can spike, but we've never come from such low levels," says Kim. The companies themselves are financially healthier this cycle, with lower debt-to-capital ratios and healthy interest coverage.
A cyclical decline in housing doesn't necessarily mean all companies fare poorly. Many have big exposure in pockets of the housing market that could be more insulated from the weakening economy. Take
Toll Brothers (TOL) - Get Report, for example. Laverson says the company is building three developments in New Jersey near Hopewell, where there is little available housing and Merrill Lynch is constructing a new facility, moving about 3,000 jobs to the area. "The detail they do behind the areas they build in is amazing. It's almost like they're looking at a demand ratio of four to one
one home built for every four demanded," says Laverson, who also covered the sector as an investment banker in his former job. "Toll Brothers never had inventory. It's not like they're building something and then say, 'let's see if it sells,'" he added.
The valuations are compelling. The figure below graphs the price-to-book-value ratio on the homebuilders going back to 1991. On Kim's estimate of December book values, the group as a whole is trading at a price-to-book-value ratio of 1.0 to 1.2, down from well over 2.0 in 1998 but still above its previous low of 0.8 in 1991, when the real estate market was financially distressed. I think the downside in the stocks could be about 20%, back to book value ratios of between 0.8 and 1.0, which is where the stocks have typically bottomed. The upside, however, could be another doubling, or back to book value ratios of 2.0.
Homebuilder Stocks Are at Low Valuations
One stock that both Kim and Laverson seem to agree on is
, a geographically diverse homebuilder with operations in 23 states. The stock is off 23% from its 52-week high. Laverson says the company is very well-managed and cheap, trading at a price-to-earnings ratio of 6.6 on 2002 estimates of $3.50. It's also trading at a price-to-book-value ratio of 1.2. Kim likes the company's focus on the "semi-custom" segment of the housing market, which earns the company a higher gross margin than the typical "volume" homebuilder. He also likes the company's recent acquisition of Schuler Homes, which should add to earnings right away. Kim rates D.R. Horton an outperform. His firm, Salomon Smith Barney, has been involved in banking transactions for the company.
Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to