November 18, 2013 - How to Prepare for Potential Housing Weakness
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 could stall.
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 appeared.
Over the last few weeks, Ryland Group (RYL), DR Horton (DHI), and PulteGroup (PHM) 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 stalling.
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 arrives.
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 (ITB) exchange-traded fund.
Among ITB's top holdings are PulteGroup, Lennar (LEN), DR Horton (DHI), 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.
Chart courtesy of stockcharts.com
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.