Those betting against another rally in the housing sector this year should brace for more pain. With home sales expected to hit a record in 2004, according to Fannie Mae ( FNM), and interest rates projected to remain low for much of the year, the environment for housing stocks still looks good. "I think the homebuilding business is as strong as it's been any time in the last three or four years," said Ken Heebner, manager of the CGM Realty fund. "The industry at the moment has everything going for it." Housing stocks surged 63% on average last year, as a record 1.09 million new homes were sold. Although economists had expected a slight falloff in sales this year, Fannie Mae now believes another record is possible, thanks to persistently low interest rates. Economists aren't expecting a change in interest rates Tuesday and most say any change in the Fed's policy statement will be extremely subtle. Asha Bangalore, an economist at Northern Trust, said the central bank might say that the risks of disinflation are now equal to the risks of inflation. In the last statement, the Fed said the odds of a welcome fall in inflation are almost equal to that of a rise in inflation. "It's going to be minor," she said, adding that she doesn't expect a rate hike until sometime in 2005. The national average interest rate on a 30-year fixed mortgage recently fell to 5.41%, its lowest level since July, as expectations for an interest rate hike by the Federal Reserve were pushed out following a much-weaker-than-expected jobs report for February. In recent weeks, numerous companies have been raising earnings guidance and reporting extremely strong order growth. Toll Brothers ( TOL) said it expects full-year earnings to rise 20% over 2003 levels, making it another record year for the firm. D.R. Horton ( DHI) and Hovnanian Enterprises ( HOV) have both raised their earnings forecasts for 2004 and Centex ( CTX) recently said orders rose 21% for the first eight weeks of the fourth quarter.
One of the reasons analysts are so enamored with the sector right now is because supply remains tight, due to an increasingly lengthy and costly land approval process. "A hugely important, powerful factor in California, Nevada, Baltimore, Washington, Pennsylvania, New Jersey and parts of Florida is there is a shortage of good building sites," said Heebner. "That means the homebuilders that operate in those markets are in the driving seat." Firms like Pulte ( PHM), Lennar ( LEN) and D.R. Horton all operate in these areas and are able to raise prices aggressively, analysts say. Supply is also being held down by the homebuilders themselves, who are much more disciplined than they once were. Back in the 1980s, the mentality among housing companies was "build and they will come." Today, most builders don't construct new homes unless they have orders. "They're not building on spec anymore," said Ron Muhlenkamp, portfolio manager of the Muhlenkamp Fund. "We think the companies are much better run than they used to be." Demand also remains strong due to low interest rates and favorable demographics. Although bears worry about an immigration slowdown in the wake of 9/11, the number of people coming into the country has remained steady over the past two years. Jim Wilson, an analyst at JMP Securities, said demand has been running modestly ahead of supply for "quite a few years" amid continued growth in the population and a high divorce rate in the U.S., which turns one household into two each year. Analysts say affluent areas like California are particularly strong right now, while places like the Midwest are seeing weaker demand because the job market is still poor. Another positive development in the housing sector recently has been the increased consolidation. Many larger companies have been gobbling up smaller competitors in acquisitions that are accretive to the bottom line and add to market share.
"I think you'll continue to see consolidation; the big firms will continue to get market share from what we call the neighborhood man with the hammer," said Muhlenkamp. Large builders now control more than 20% of the market, up from just 5% in 1991, according to Keebner, who expects that number to grow to as much as 50% going forward. Despite all of these favorable trends, housing stocks continue to trade at just 8 or 9 times 2004 earnings estimates. "We're well below the average," Keebner said, noting that the group traded at 11 times forward earnings between 1984 and 2002. "These stocks are selling at a lower multiple than they did in the '90s, when the industry was much less well positioned." Muhlenkamp said homebuilding stocks "deserve to double" in price, given many of the solid fundamentals, and Wilson said a 40% jump wouldn't be out of the question because he believes that many firms will exceed current earnings estimates by 20% to 30%. Still, the specter of higher rates at some point later this year or next continues to loom, and it's for this reason that the stocks aren't garnering a higher multiple.
Because rates are so low right now, analysts say a modest rate increase would have little impact on sales. In fact, some say a rate hike would imply that the economy is much stronger, which could mean more people are looking to buy homes. But the psychological impact of a rate hike could be damaging to housing stocks. "I think there's room for rates to rise before it hurts the industry but how much investors will tolerate this is hard to know," Keebner said. When perception and reality move out of alignment, however, Muhlenkamp said there's an opportunity to make profits. "If you take any other industry with this kind of growth and this kind of profitability, the stocks would sell twice as high," he said. "If these things were at 30 times earnings, I'd worry about higher rates. At 8 times earnings, I'm not worried at all."