One small step for the U.S. housing market, one giant leap for home-building stocks.
That’s one way to describe this corner of the stock market, where even tentative improvements in the housing sector have been translating into big share-price gains.
So far this year, home-building stocks within the S&P 500 have led all 154 industry groups within the benchmark index. But despite the big moves, these stocks still look like an ideal way to bet on more improvements in the housing sector ahead.
In the latest example of a slight improvement, the Case-Shiller home price index for April – released on Tuesday – showed that prices among 20 U.S. cities rose 0.7 per cent from the prior month after adjusting for seasonal variations. Prices fell 1.9 per cent on a year-over-year basis, but that marked the slowest pace of deterioration in more than a year, beat expectations and pointed to some semblance of stabilization.
“Today’s figures are encouraging and suggest the U.S. housing market may have turned a corner, albeit with a strong recovery still appearing unlikely with high unemployment hampering the sales outlook,” said Andrew Grantham at CIBC World Markets.
Sure, that’s a lukewarm assessment, but it’s good enough for the stock market. The three-member S&P 500 home-building index rose more than 4 per cent on the report, bringing its year-to-date gains to nearly 42 per cent.
These gains come even with the Federal Reserve continuing to describe the housing sector as “depressed.” Imagine where these stocks will be when the Fed changes its tone.
You can see where the Fed gets its dour assessment, of course. The improvements we’ve seen – gains in new home sales, decreases in unsold inventories, upticks in builder confidence – are coming from exceptionally low levels and remain far below where they were when the housing sector was humming.
Just look at housing starts: In May, builders began work on 708,000 residential units, at a seasonally adjusted annualized rate. That’s above recent lows – but consider that for the fifty years prior to the housing bust, starts never dipped below 1-million units and they were generally above 2-million units between 2003 and 2006.
Meanwhile, the home builders themselves remain cautious in their outlook. The chief executive of PulteGroup Inc., a mid-sized home builder, reacted in April to the company’s first-quarter financial loss by saying that “housing demand may have reached a positive inflection point,” which hardly sounds like a table-pounding buy.
Analysts are also taking a similar reserved approach, with the majority giving “hold” recommendations on home builder stocks.
So why are investors so excited?
The market likes to look ahead, and early signs of a healthier housing market suggests that the upside potential for home-building stocks could be huge. Few other sectors of the stock market were pummelled as badly as home builders during the downturn, making the possible recovery just as big.
The S&P 500 home-building index plunged 90 per cent from its peak in 2005 to its trough in 2008, acting as a leading indicator for the broader market. Although the home-building index has since rebounded 200 per cent, it is still 70 per cent below its peak and roughly back to where it was 10 years ago.
Even though the peak marked a speculative bubble – and won’t likely be seen any time soon – the current share prices imply that these stocks remain contrarian bets.
Investors can also see that companies that survived the downturn are well positioned to ride any upturn – generally, with loads of cash, low debt loads and lean operations.
The iShares Dow Jones U.S. home construction index exchange traded fund gives you an easy way to gain access to the entire sector. It holds 27 different stocks, though some – like Home Depot Inc. and Ethan Allen Interiors Inc. – stray from actual home building.
Individual stocks will give you purer exposure to the industry, though this approach comes with greater risk of course.
Toll Brothers Inc., a luxury home builder, and NVR Inc. represent a more conservative approach. These stocks showed financial resilience during the worst of the downturn and have since rebounded the most. For example, NVR shares are just 12 per cent below their peak and are close to a five-year high. While the downside might be limited here, the upside is too.
For a wilder and woolier approach, look to companies that continue to struggle but whose fortunes will improve dramatically with a meaningful turnaround in the housing sector. Among the candidates: PulteGroup and D.R. Horton Inc.
For these stocks, the recovery in the housing sector still looks like a distant dream.