Homebuilders: The Recovery Looks Overdone

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Construction in general, and homebuilding in particular, has been a volatile sector of the stock market in the last few years. In many ways, the sector is a perfect example of my theory that financial markets have a natural tendency to overreact to news and sentiment, both good and bad.



The above chart for the SPDR Homebuilders ETF (XHB) detailing its activity since its inception about 7 ½ years ago illustrates the point. It is now obvious that the sector was hugely overvalued in 2006, but the drop as the recession unfolded was spectacular. Of course, there were very good reasons for that and it is hard to say that those low levels were unjustified given sentiment at the time but as a result, volatility during the climb back has been extreme.



Even given the last couple of days of drops for XHB, it is hard to see much upside to buying the stock and the downside risks look significant.

From a technical perspective, XHB looks to have recently bounced off of a level (blue line) that represents a 61.8% retracement from the initial decline. For those of you unaware why a seemingly random number such as 61.8% should have significance, it is a Fibonacci retracement level. Fibonacci numbers are based on the relationship between numbers in a sequence sequence, but all you really need to know is that it is a level that many traders watch.

My reasons for caution, however are based on more than the proximity to a particular mystical number. Looked at over the long term, the recovery in XHB, and housing stocks in general, may be almost as overdone as the initial collapse turned out to be. As news about the housing sector has improved, and as time has gone by, the market has begun to price the sector as though the problems are over.

In fact, if you do still believe, then many believe something like XHB may be the best way to play the sector. The fund does not just consist of the homebuilders, but also the suppliers such as Lumber Liquidators (LL) and Lowes (LOW). This does give some exposure to home improvements as well as sales and therefore some diversification, but both LL (+112%) and LOW (+57%) have appreciated significantly in the last year and may be running out of steam. The forward P/Es for LL and LOW are 35.24 and 22.15 respectively. Forward P/E is based on analysts’ estimates of future profit which have some growth expectations baked in, so to justify these valuations growth will have to be pretty spectacular.

The homebuilders individually are no better. Toll Brothers (TOL) has a forward P/E of 19.32 and KB Homes (KB) 17.81 for example. In the context of all companies, these aren’t excessive, but given the assumptions behind projections they look a little rich.

When the Fed announced last week that tapering would not begin this month as many had suspected, housing stocks in general jumped. The prospect of continued low interest rates gave them a boost, but does anybody expect QE and the Fed’s ultra-low interest rate policy to continue forever? Sooner or later interest rates will return to normal. That realization has caused XHB and other stocks in the sector to give back some of those gains.

All of the above mentioned stocks, XHB, LL, LOW, TOL and KB look significantly overvalued. The housing recovery on which the optimism around them has been based is showing signs of stalling. The Government, in an attempt to stem the rush of foreclosures instituted a number of refinancing programs, such as HARP and HAMP, but the recent news from the mortgage originators would indicate that the number of refinances is beginning to slow.

This was inevitable as rates began to rise in anticipation of tapering, but the fact that the mortgage companies had become so dependent on refinancing is a definite red flag for the homebuilders. House prices have recovered somewhat, but there are still an enormous number of people who are too far upside down to move and I worry that the recovery, such as it is, will be severely limited for a while to come.

In short, then, I don’t believe it will be possible for the homebuilding sector to achieve the kind of growth that is currently priced in to many of the stocks. The slow recovery in house prices will probably continue, but there are bound to be bumps along the way. In a volatile sector, those bumps will put enormous pressure on the individual stocks, so, for now, there are probably better places to put your money than bricks and mortar.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks , Investing Ideas , Retirement

Referenced Stocks: KB , LL , LOW , TOL , XHB

Martin Tillier


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