BofA Securities upgraded KB Home to Buy from Neutral based on its low price/book ratio relative to its return on equity.
Patrick T. Fallon/Bloomberg
Home may be where the heart is, but no one should fall in love with home-builder stocks right now.
Home builders have gotten walloped in January, and like just about everything else it can be blamed on the Federal Reserve. The SPDR S&P Homebuilders exchange-traded fund (ticker: XHB) started the year sitting near its all-time high. But the minutes from the Fed’s December meeting, which were released on Jan. 5, revealed a far more hawkish tone than the market had expected. The stock market sank, and so did housing stocks, with the Homebuilders ETF dropping more than 14% through Jan. 21.
That a more aggressive Fed would hurt home builders shouldn’t come as much of a surprise. Higher federal-funds rates mean higher home-loan rates, all else being equal, and that’s exactly what has been happening: The average rate on a 30-year mortgage has risen to 3.55% from 3.11% at the end of December, according to Freddie Mac. And higher rates should slow home sales, as they’ll put homeownership out of reach for some prospective buyers. Housing activity has been slowing, with single-family home starts dropping in all but one of the last seven tightening cycles, according to UBS data.
Housing activity, however, already looked set to slow, with or without the Fed. Pending home sales fell 3.8% in December from November, according to the National Association of Retailers, which blamed the drop on a lack of homes for sale. But there’s also a good chance that higher prices—they rose 18.8% in November year over year, according to the S&P CoreLogic Case-Shiller Home Price Indices—are giving some buyers second thoughts or simply pushing a new home out of their price range, explains Peter Boockvar, chief investment officer at Bleakley Advisory Group. “The NAR is blaming the lack of inventory, but we can’t discount also the spike in home prices that in turn dissuades some possible buyers,” he writes.
Then, Fed Chairman Jerome Powell had to go and try to convince financial markets of his inflation-fighting credibility. The fed-funds futures market now reflects a 66% chance of six rate hikes in 2022, up from 13% just a month ago. Four rate hikes are nearly a given. And let’s get one thing straight—tightening cycles are historically pretty lousy for housing stocks. During the last seven hiking cycles, housing stocks outperformed twice, managed to finish higher but underperform once, and fell four times, according to UBS data.
Yes, housing stocks already reflect a lot of this pain. UBS analyst John Lovallo notes that the average home-builder stock traded at just seven times 2023 earnings on Jan. 19, suggesting that the market has already adjusted to the possibility of Fed rate increases and slower home sales. Yet Lovallo contends that there’s enough pent-up demand to keep sales going, which could cause multiples to grow by 50% and more than offset declines in earnings estimates. “Builder stocks could spring this spring,” he writes.
Valuing home builders off earnings, however, may not be so au courant anymore. Traditionally, they’ve been valued on price-to-book ratios, and BofA Securities analyst Rafe Jadrosich switched back to that metric from price/earnings in a Jan. 27 report, arguing that most home builders had profit margins that were “unsustainable.” As a result, the price that investors will be willing to pay going forward will probably be based on the return on equity of the home builder, with stocks that have better returns earning higher valuations.
Jadrosich downgraded Toll Brothers (TOL), known for its upscale homes, to Underperform from Buy, citing, in part, its higher price-to-book ratio relative to its ROE and the fact that as rates rise, homeowners might simply choose not to move up. He cut Lennar (LEN) to Neutral from Buy, because it trades at 1.3 times P/B, a level reserved for companies with higher ROEs. He upgraded KB Home (KBH) to Buy from Neutral based on its low P/B relative to its ROE, and left his Buy rating intact on D.R. Horton (DHI), citing its asset-light model and a focus on entry-level housing.
“We continue to have a constructive view on the underlying drivers for new homes and renovation demand,” he explains. “However, we see a more challenging setup for stock outperformance with rising interest rates and a potential earnings peak in 2022.”
Still, his price targets suggest further gains in all four stocks, something that may prove optimistic. Part of the problem is simply the massive rally that home builders have staged over the past three years. The SPDR S&P Homebuilders ETF has returned 170%, including reinvested dividends, from the beginning of 2019 through the end of 2021, easily outperforming the SPDR S&P 500 ETF’s (SPY) 100% return over the same period.
Perhaps most concerning is that D.R. Horton, Lennar, Toll Brothers, and M.D.C. Holdings (MDC) all looked like they were about to break out, according to 22V Research technical analyst John Roque, but failed to do so, something that often leads to bigger breakdowns. Their 40-week moving averages are also starting to roll over, as is relative performance to the S&P 500 index. For Roque, the conclusion is obvious.
“In short, these four stocks should be sold,” he writes. “Shorted if you can.”
At least until the Fed has a change of heart.
Write to Ben Levisohn at [email protected]
