In November 2016, things didn’t look pretty for home-builder stocks. A confluence of headwinds really weighed on the sector. Economists were calling for an economic recession, home-builder activity dropped due to adverse weather conditions, mortgage rates rose as inflation expectations picked up and renting remained the Millennial fad.
But that sell-off in home-builder stocks proved to be a buying opportunity. Home-builder stocks have roared higher in 2017 as interest rates have remained low, unemployment has contracted, wages have grown, builder confidence has soared and Millennials have started buying homes.
NVR, Inc. (NYSE:NVR) has led the pack with year-to-date gains in excess of 45%. PulteGroup, Inc. (NYSE:PHM) is up more than 30% year-to-date, while Lennar Corporation (NYSE:LEN), William Lyon Homes (NYSE:WLH) Toll Brothers Inc (NYSE:TOL) and D.R. Horton, Inc. (NYSE:DHI) are all up more than 20% in 2017.
One home-building company, KB Home (NYSE:KBH), is set to report Q2 earnings after the market closes on Tuesday. KBH stock, like its peers, is up 43% year-to-date. Against the backdrop of the current macroeconomic housing picture, KBH looks like a sure thing into earnings.
And it might be. But investors should exercise caution with KBH stock and the rest of the home-building sector.
KB Home Has Plenty of Tailwinds, But How Long Can They Last?
For those unfamiliar with the KBH story, KB Home constructs and sells homes primarily for young, first-time home buyers. Their core geographic markets include California, Arizona, Nevada, Colorado, Texas, Florida and North Carolina.
These are very attractive features for a home-builder in the current housing environment. After years of opting to rent over owning a home, millennials are finally entering and powering the housing market. KB Home specializes in servicing this demographic. Moreover, its key real estate markets, California and Florida, remain on fire. KBH also employs a built-to-order model, which allows the company to move with demand and minimize speculative inventory.
Undoubtedly, KBH stock offers a unique home-builder growth story with company-specific tailwinds. That doesn’t, however, exempt it from exposure to what looks like are risks ahead for the entire home-builder space.
The whole housing market right now is being propped up by a confluence of perfectly timed tailwinds. Interest rates are low, so mortgages are affordable, but everyone also expects interest rates to rise sometime in the near future. That is causing an unnatural surge in mortgage application volume. Meanwhile, the U.S. economy is either at or past full employment. Under-employment continues to fall. Wages continue to tick up at a modest 2-3% rate. The stock market continues to grind higher.
Because of this, real estate demand is high and home-builder stocks continue to report really good numbers. Lennar Corporation reported strong Q2 results on June 20, and management commented on the call that California and Florida (two of KBH’s biggest markets) performed exceptionally well in the quarter. Toll Brothers, who also has a single-family home presence in the California/Florida/Texas markets, reported strong quarterly numbers and boosted guidance on May 23.
KBH will likely follow suit on Tuesday afternoon with equally impressive numbers.
But how long can this Golidlocks housing market last?
Recent data implies that the run may be coming to an end. Labor and lot shortages are beginning to weigh on home-builder confidence, and that is dampening the housing market’s growth prospects. Housing starts hit an eight-month low in May, while building permits fell to their lowest level since April 2016. In the longer-term outlook, interest rates can’t stay low forever and automation seriously threatens the currently healthy U.S. labor situation.
Despite these warning signs, though, KB Home and other home-builder stocks continue to grind higher. Investors seem to be focused on the strong earnings reports, which give a look at the last three months, as opposed to the home-builder confidence and housing starts data, which gives at look at the next 3-plus months.
In other words, it looks like home-building stocks are being valued based on what has happened, not what will happen.
That makes KBH stock a dangerous place to be in a long-term window.
Bottom Line on KBH Stock
Full employment, currently low interest rates, a fear of higher interest rates in the future, stable financial market growth and high consumer and builder confidence are all contributing to a Goldilocks housing market. Consequently, home-builder stocks have roared higher in 2017.
But cracks are starting to show in the growth narrative. Investors seem to be ignoring these warning signs and instead are focusing on the slew of good earnings reports from the country’s major home-builders.
KB Home is the next major home-builder to report earnings. The numbers will likely be very good, management will likely sound very bullish and KBH stock will likely go up.
But that is a rally that investors should consider fading. Home-builder stocks are currently out over their skis, and a pullback is necessary for the reality of a slowing housing market to match the now out-sized valuations.
As of this writing, Luke Lango was long KBH.