While some believe homebuilder stocks still have room to run, I personally see signs of an imminent slowdown and break in momentum. If we look at the SPDR Homebuilders ETF (NYSEARCA:XHB), we can see a nasty drop that could usher in more meaningful declines in the months ahead.
Before diving into the bearish argument, it’s crucial to understand the homebuilder sector’s dynamics. Homebuilder stocks like LGI Homes (NASDAQ:LGIH), Lennar (NYSE:LEN), D.R. Horton (NYSE:DHI), Pulte Homes (NYSE:PHM), and Toll Brothers (NYSE:TOL) have capitalized on a robust housing market bull market post Covid-19. However, with rising interest rates and increasing market volatility, concerns of a new housing bubble are emerging. And to the extent that we may be near a credit event, these stock prices could collapse.
Let’s delve into the reasons for adopting a bearish standpoint toward homebuilder stocks.
1. Rising Interest Rates
Interest rates have a direct impact on the housing market. As rates rise, mortgage loans become more expensive, which can deter potential homebuyers. Long-duration Treasuries, as measured by the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT), have gotten destroyed as of late, and mortgage rates will spike further as a result.
2. Economic Projections and Their Implications
The Federal Reserve’s Summary of Economic Projections (SEP) provides a glimpse into policymakers’ views on economic conditions. A closer look at the SEP reveals an expected slowdown in GDP growth and an increase in core PCE inflation expectations for the coming years. These factors could lead to a less favorable environment for homebuilders.
3. Overreliance on Mortgage Rate Buydowns
Mortgage rate buydowns have become a popular tool among homebuilders to stimulate sales amidst rising interest rates. However, this strategy may not be sustainable in the long run. Rate buydowns often involve reduced payments in the initial years, which later reset to higher rates. If rates continue to rise, the reset could lead to substantial payment hikes, potentially leading to increased loan defaults and cancellations.
4. Overbuilt Housing Market
Homebuilders have been on a construction spree over the past few years, leading to an overbuilt housing market. Deutsche Bank researchers have argued that the housing market is “under-built,” but this view may be overly optimistic. The influx of new homes could lead to an oversupply, pushing prices down and impacting homebuilders’ profitability.
5. High Leverage and Cyclical Nature
Homebuilders are typically highly leveraged, meaning they rely heavily on borrowed money to finance their operations. This high debt level can be risky in a rising interest rate environment, as it increases the cost of servicing debt. Moreover, the homebuilding industry is highly cyclical, with periods of rapid expansion often followed by sharp contractions.
6. Deteriorating Affordability and Demand
While home prices have been rising, wage growth has not kept pace, leading to deteriorating housing affordability. This could result in decreased demand for new homes, affecting homebuilder sales and revenues.
While homebuilder stocks have enjoyed a strong run this year, several signs point toward potential trouble ahead. Rising interest rates, economic projections, overreliance on mortgage rate buydowns, an overbuilt housing market, high leverage, and deteriorating affordability all contribute to a bearish outlook.
If there’s a credit event as I expect, homebuying collapses, alongside homebuilder stocks.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
