Wait Before Hopping Into Home Depot

by Ethan Roberts | May 21, 2013 1:11 pm

Less than two years ago, the U.S. real estate market was still struggling to find its bottom and Home Depot (HD[1]) was selling for about $30 a share.

This morning, after a stellar first quarter earnings report in which Home Depot beat analyst expectations and raised its sales and profit outlook for 2013, the stock is breaking out to new highs just under $80.

Home Depot’s sales were up 7.4% to $19.12 billion in the first quarter, which ended May 5. Analysts had been expecting $18.68 billion. Net income of $1.2 billion exceeded $1 billion a year ago, and Home Depot earned 83 cents per share, up from last year’s 68 cents per share and above expectations of 77 cents per share.

To top it off, Home Depot raised its annual forecast from $3.37 to $3.52 cents per share, while forecasting a sales increase from of 2.8% instead of 2%.

A stronger housing market is a main reason for Home Depot’s continuing success. Realtrends.com reports[2] that there were 5.731 million closed sales in April, up a colossal 16.2% from the 4.932 million recorded a year ago.  Both new and existing home sales were higher. Although inventory remains low, first time buyers are flocking to take advantage of low interest rates and prices while they last. Plus, cash investors continue to jump on low-priced foreclosures and short sales.

This was not lost on Home Depot CEO Frank Blake, who commented, “We continue to see benefit from a recovering housing market that drove a stronger than expected start to the year for our business.”

When the housing market is strong, retailers such as Home Depot and Lowe’s (LOW[3]) benefit because first-time buyers need new items for their homes, such as lawn equipment, patio furniture, window treatments and light fixtures. Similarly, cash investors who are rehabbing investment properties are each spending thousands of dollars in these stores on appliances, flooring and electrical or plumbing materials.

A second reason for Home Depot’s recent success that is often overlooked is the “wealth effect” — a result of rising prices of both the stock and real estate markets since the Fed’s QE3 program was initiated in 2012.  QE3 has pushed interest rates down to historic lows, propelling both markets higher. When people feel wealthier, they spend more money on big ticket household items. Rising home values have been found to create the wealth effect, even though home owners don’t typically benefit from that until and unless they sell.

However, this week there are concerns that QE3 is about to either end or start winding down. The question going forward, then, is what effect that could have on the real estate market. Will interest rates rise significantly, and will that slow both home values and sales?

And the same question can be asked of stocks. Will an unwinding of QE3 finally lead to the big correction that has been so widely anticipated for months, but has yet to occur?

A correction in both of these markets would considerably impact on Home Depot and Lowe’s, which is also due to report before the bell on Wednesday.

Therefore, my advice to investors would be to wait for the Fed’s announcement before jumping in to purchase Home Depot at this lofty level. If you are holding shares of Home Depot stock, you may want to tighten your stops. If there is no planned end yet for QE3, then HD should remain strong for awhile longer.

However, if the Federal Reserve announces an unwinding or end to the QE3 program, I believe we will see both HD and LOW trade at significantly lower prices in the months ahead. As you can see from the accompanying chart, a move back to the 50-day moving average just below $73 would be the most likely first target. After that, we will have to re-evaluate the effects of any changes to QE3 on the real estate market, along with its correlation to stocks such as Home Depot and Lowe’s.

HD Wait Before Hopping Into Home Depot

As of this writing, Ethan Roberts did not own a position in any of the aforementioned securities.

Endnotes:
  1. HD: http://studio-5.financialcontent.com/investplace/quote?Symbol=HD
  2. Realtrends.com reports: http://realtrends.com/blog/real-trends-real-estate-housing-market-report-may-2013
  3. LOW: http://studio-5.financialcontent.com/investplace/quote?Symbol=LOW

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