How to prepare for potential housing weakness
Michael Fowlkes 11/18/2013
The housing market has gradually improved over the last few
years, fueled by the Federal Reserve's low interest rate policy.
For as long the Fed keeps its monetary policy intact, housing
will continue to improve, but once the Fed starts to taper its
monetary easing there is a real threat that the housing recovery
While homebuilders will feel the pinch of lower interest
rates, companies in the home improvement sector would likely
benefit. The reason being that if the housing market starts to
weaken, people will be forced to stay in their homes longer, and
increase demand for home improvement supplies.
This week, a long list of home improvement companies will
report their most recent quarterly numbers, which I expect to be
strong. On the other hand, a lot of homebuilders have already
announced their quarterly results, and a couple of big red flags
Over the last few weeks, Ryland Group (
), DR Horton (
), and PulteGroup (
) have all reported quarterly earnings.
Ryland posted earnings of $0.95 per share, topping analyst
estimates by $0.07. PulteGroup easily topped analyst estimates of
$0.34 with a reported $0.45. Lastly, DR Horton posted earnings of
$0.40 per share, which was in-line with analyst estimates, but
the company did miss its revenues estimate.
At first glance, these results would signal that the housing
market is on solid footing, but upon closer inspection you will
find this is not necessarily the case.
DR Horton reported a 2 percent drop in orders during the
quarter. PulteGroup reported its orders were down 17% in terms of
volume, and 8% in terms of dollar value. Ryland was the standout
of these homebuilders, reported that orders were up 6.1% in
volume and 33% in terms of dollars.
Even more alarming for DR Horton, was that it had a
cancellation rate of 31%
during the quarter.
Lower orders, and DR Horton's high cancellation rate provides
good evidence that the recovery in the housing market could be
Even with the Federal Reserve not changing its monetary
policy, interest rates have been creeping higher. The basic
assumption is that Fed tapering will occur soon and interest
rates are rising in anticipation of when that day finally
The average 30- year fixed mortgage rate is currently sitting
at 4.35%. This time last year, the average rate was just 3.34%,
so clearly rates are moving higher, regardless of the Fed not
tapering its monetary easing.
Historically speaking, mortgage rates are still incredibly
low, but the year over year increase has spooked would-be
homebuyers, and a reason why orders are declining.
Another indicator that the market is headed for trouble is the
drop in September pending home sales. The Pending Home Sales
Index, as tracked by the National Association of Realtors dipped
5.6 percent during September.
A report showing that the economy added 204,000 during the
month of October has brought the issue of Fed tapering back to
the forefront, with a lot of analysts believing the Fed
may start to taper as early as December
. If this holds true, then there is a significant amount of
downside risk to homebuilder stocks.
A lot of uncertainty remains in the housing market. With so
many mixed signals, it is tough to really gauge the current
situation, but I believe there are enough red flags for investors
to be concerned.
Even if the housing market does continue to improve, I see
limited upside to home construction companies. Investors will
continue to focus on the possibility of Fed tapering, which will
put a cap on the sector's upside. Conversely, I do believe there
is a significant amount of downside risk.
As a result, for traders who want to play the sector, I would
suggest a bearish trade on the iShares US Home Construction (
) exchange-traded fund.
Among ITB's top holdings are PulteGroup, Lennar (
), DR Horton (
), Home Depot (HD), and Lowe's (LOW). The ETF has exposure to
home improvement companies, but is weighted much more heavily
towards the homebuilder group.
ITB has posted a gain this year, but a modest one, with the
stock rising just 7.7% year to date.
A nice hedged trade on ITB would be the January 25/27
bear-call credit spread. In this trade, you would sell the
January 25 call while buying the same number of January 27 calls
for a credit of 20 cents. The target return of this trade is
11.1%, which is 63.4% on an annualized basis (for comparison
purposes only). ITB is currently trading at 22.77, which provides
this trade with 10.7% downside protection.