2023-04-03 17:20:16 ET
Summary
- The US homebuilding stocks represented by the two ETFs (ITB and XHB) are up +10% YTD.
- We think this move doesn’t make sense as the fundamentals have not improved and the macro backdrop is still not supportive.
- The fundamental picture could get worse if the employment number starts to crack.
- The equity valuation is not particularly cheap post this recent bull run.
- We are bearish on the homebuilding sector and would outright short this as a portfolio hedge.
Investment Thesis
Despite a year-to-date return of +10% for US homebuilding stocks, we find it difficult to justify based on industry fundamentals and the macro backdrop. The US housing market remains highly unaffordable, leading to a high volume of order cancellations for homebuilders. Additionally, the ongoing regional banking crisis is likely to further tighten liquidity in the system, making it harder to secure a mortgage. While employment numbers are still strong, there are increasing reports of layoffs. Furthermore, homebuilding stock valuation is not particularly cheap. As a result, we are becoming more bearish on the homebuilding sector and recommend using this sector as a portfolio hedge.
Business Overview
The homebuilding business model is uncomplicated and follows a simple cycle: land acquisition and development, home construction, home marketing, and home sales. The success of a homebuilding enterprise relies on various factors such as the demand for new homes in the market, material and labor costs, and the effectiveness of marketing and sales efforts. Publicly-traded homebuilders generally generate a gross margin in the mid-to-high 20% range and an EBIT margin in the high teens.
US Homebuilders Margin (Seeking Alpha)
Homebuilding is a capital-intensive industry, with homebuilders requiring a constant influx of new land and home construction to maintain revenue growth. Consequently, during periods of economic downturn, homebuilders with high levels of land and home inventory at varying stages of development can experience severe supply and demand mismatches. This can lead to a significant decrease in new home sales, and in some cases, homebuilders may need to take write-downs on their inventories. The 2008 Great Financial Crisis serves as a prime example of this phenomenon.
Despite the challenges, homebuilders possess a certain degree of resilience, as they have the ability to generate cash flow by ceasing to reinvest in new land and homes. Running off existing inventories can generate significant cash flow, albeit at the cost of sacrificing future earnings potential. However, this strategy can provide a level of downside protection for equity.
Macro Backdrop
The homebuilding sector is heavily influenced by macroeconomic factors. While some differentiation exists among homebuilders based on their geographic concentration and customer segmentation by income level, the stocks within this sector remain highly correlated with each other. Any company-specific factors are overshadowed by relevant macroeconomic factors, and analyzing this sector involves assessing supply and demand factors at the industry level.
Regarding supply, it is well known that the US has been under-building homes since the GFC. The housing starts chart below demonstrates how an oversupply built up leading to the GFC, followed by a crash and a failure to return to pre-GFC levels. Following a peak during COVID, housing starts experienced a significant decline as mortgage rates more than doubled from 3% to over 6% within the past year.
Another method of assessing supply is to examine the months of supply of new homes, which is calculated by dividing new home inventories by monthly new home sales. As seen in the chart, the US experienced a temporary oversupply following the GFC, which gradually reduced over the course of more than a decade. The recent increase in supply is due to a sudden slowdown in new home sales resulting from affordability issues, rather than an inventory glut.
So far we have established that the US housing market suffers from a structural undersupply issue . However, due to the inelasticity of supply, the health of the US homebuilding sector is more heavily influenced by the demand outlook. In simple terms, housing demand is determined by affordability, which in turn is determined by three factors: housing prices, mortgage rates, and employment rates. The average working-class individual typically determines their mortgage payment based on their bi-monthly paycheck and tends to maximize their borrowing capacity. As of now, the median new home sales price is 35% higher than pre-COVID levels. While the median home price peaked in Q3-2022, there is still a long way to go to return to the trendline.
Between 2020 and 2021, the 30-year mortgage rate remained below 3%. However, it has since increased due to the Fed's hiking cycle, reaching a high of 7%. While the mortgage rate has since decreased and remains relatively low compared to the long-term historical average, it is still shockingly high for a population accustomed to a low-rate environment.
The combination of high housing prices and a mortgage rate exceeding 6% has resulted in a housing market that is extremely unaffordable , as shown by the housing affordability index below (where lower scores indicate less affordability). However, the current robust employment market serves as a mitigating factor against this issue. Historical data suggests that the housing market is unlikely to crash as long as people remain employed. Additionally, life events such as marriage or a new baby may force individuals to purchase a home, although they may settle for a smaller home or make a higher down payment to save on interest costs. In other words, despite the challenges there is always some level of structural demand for housing. Furthermore, homebuilders are offering rate buydowns to help ease affordability concerns.
Housing Affordability Index (National Association of Realtors) Unemployment Rate (FRED)
It's crucial to remember that employment is a lagging indicator, with companies often waiting until they have no other choice before making job cuts. This is especially true given the challenges in hiring workers since the COVID pandemic began. While employment figures have remained strong, it's unlikely that this will continue in the future. We are increasingly seeing more announcements of layoffs from companies, and this trend is confirmed by the rise in the Challenger Job Cuts data.
U.S. Challenger Job Cuts (Challenger, Gray & Christmas)
Those who are bullish may argue that during an economic downturn, housing prices will correct themselves, and the Fed will cut rates, ultimately solving the affordability issue. However, we do not agree with this stance. Unlike in 2008, when consumers were highly leveraged, as of the 2018 Census almost 40% of US homes are currently mortgage-free. We do not anticipate any forced selling to impact the housing market, certainly not to the same extent that was experienced during the GFC. Additionally, the Fed's economic projections indicate that they are not in a rush to cut rates to an accommodative level, even if the economy slows down. Therefore, our base case is that even if the economy experiences a soft patch and employment rolls over, US housing will remain relatively unaffordable. If widespread layoffs were to occur, it would significantly worsen the fundamentals of the homebuilding sector, as strong employment is currently the only factor supporting the sector.
GDP Projection (Federal Reserve) Dot Plot (Federal Reserve)
Valuation
Given the balance sheet-heavy nature of homebuilders, the market typically values these stocks based on their price-to-book ratio. Recent market developments have left us somewhat perplexed. For example, KBH experienced a market repricing lower in 2H2022 due to the housing affordability issue being a top concern. Yet, despite the affordability issue remaining unresolved and the economic outlook worsening, KBH's valuation has rebounded. From our perspective, homebuilding stocks are currently overvalued, even when compared to current fundamentals. Furthermore, we anticipate these fundamentals to deteriorate further as the employment side of the equation begins to falter, exacerbating the overvaluation of homebuilder stocks.
An alarming trend we've observed is the divergence between lumber prices and homebuilding stocks. Historically, lumber prices and homebuilding stocks maintained a high correlation (with the exception of the anomalous COVID period). However, more recently, homebuilding stocks (represented by the ETF ITB) have experienced a bull run while lumber prices have significantly dropped and remained depressed. We anticipate that homebuilding stocks will eventually follow the trend of lumber prices and decrease in the near future.
Lumber vs. Homebuilding Stock ETF (Author)
Upside Risk
Our bearish view on homebuilding stocks carries an upside risk in the form of a soft landing scenario. This scenario is defined as the inflation rate falling to the Fed's 2% target without a recession. While we acknowledge the possibility of the Fed navigating this scenario, we find it increasingly challenging. Leading indicators suggest rough times ahead, and we are confident in our bearish stance on the homebuilding sector.
Leading Indicator (The Conference Board)
Further Downside
It's possible to envision an even bleaker scenario if the regional banking crisis that recently occurred spreads further. While we believe this likelihood is low and that the Fed is proficient at managing liquidity issues (as opposed to credit issues), we anticipate that credit availability will be reduced as a result of recent events. Securing a residential mortgage may become increasingly difficult as a result. If commercial real estate becomes the next sector to suffer, credit availability will likely shrink even further.
How to Express The View
To express a negative view on the homebuilding sector, we recommend shorting either the iShares US Home Construction ETF ( ITB ) or the SPDR S&P Homebuilders ETF (XHB). Although there are slight differences in holdings and weightings between the two, both ETFs represent a comprehensive range of homebuilders and building material providers. As a result, they track each other very closely. In terms of market capitalization, ITB is the larger of the two. After examining the holdings, we discovered that ITB contains more pureplays in homebuilding and building products, while XHB is more diversified. Therefore, we suggest using ITB as the preferred choice for expressing a bearish view on the US homebuilding sector.
ITB and XHB (Seeking Alpha) ETF Weight (Author)
Conclusion
We find the recent strong performance of the homebuilding sector (and the equity market in general) to be somewhat perplexing. It's possible that the equity market is taking its cue from the bond market, which rapidly priced in rate cuts after a couple of regional banks failed. However, when we consider the supply and demand dynamics of the US housing market, we believe there is significant downside risk. The affordability issue persists, and the support provided by strong employment is diminishing as more lay-offs are announced. The recent divergence between lumber prices and homebuilding stocks is likely a temporary phenomenon. Therefore, we suggest that this rally be used as an opportunity to enter a short position in this sector.
For further details see:
US Homebuilding: A Good Short Candidate As The Equity Is Diverging From Fundamentals