Homebuilding stocks have been the best performing of the 150-odd sectors in the Dow Jones U.S. Total Market Index, up 44.4% over the past 12 months as of November 8. Last year, they declined sharply in the face of Federal Reserve rate increases; but they began to show signs of a bottom in late November, just ahead of the Fed’s decision to reverse course on interest rates.
This year’s performance has been fueled by Fed rate cuts and their impact on housing demand. Housing had a strong first half, as buyers returned to the market as mortgage rates began to fall. Somewhat surprisingly, however, housing has remained strong even in the face of signs of a slowdown in the economy in recent months.
Continuing cuts in interest rates have undoubtedly propelled the housing market. That strength has caused me to lift my projections slightly for new home sales for the full year. Based upon the recent strength, I now anticipate that U.S. new home sales will be up 8.6% to about 670,000 units in 2019, from 6% previously. Most of that improvement has come in the 2019 second half against easy prior year comparisons.
The outlook for 2020 is unclear. Year-over-year comparisons will begin to get tougher starting in the 2020 first quarter. As long as the economy maintains its (modest) momentum, employment remains strong and consumer confidence high, demand for housing should remain solid. Yet, interest rates will continue to exert significant influence on buyers, especially at the low end of the market.
Homebuilders have been posting solid gains in new orders for most of the year. Those gains are looking stronger in the second half, against easier prior year comparisons. With seven of the eleven publicly-traded builders having reported their 19Q3 results so far, orders are up a surprisingly strong 24% on average. The gains have been driven by strong demand from first time buyers, and an increase in active subdivisions for many builders.
The average gain in 19Q3 orders is up from 10.9% in 19Q2. Order comparisons should remain strong in 19Q4, but they will become increasingly tough beginning probably in 20Q1.
In this environment, homebuilders will perform best in an economy that is neither too hot nor too cold. A rebound in manufacturing and the oil & gas sector could conceivably push GDP growth forecasts above 2%, which should support continuing employment gains and consumer optimism. However, it could also raise concerns about a pick-up in inflation, causing the Fed to reverse course once again to take back some of the recent Fed Funds rate cuts.
In 2018, the Fed seemed too aggressive in its rate increases and in its assessment of the appropriate normalized level for interest rates. I believe that the Fed Funds rate should be above its current target range of 1.50%-1.75%, but below its recent peak of 2.25%-2.50%. A Fed Funds rate of around 2%, which is equivalent to the Fed’s inflation target, would clearly be less accommodative but still supportive of housing.
In the meantime, investors in the homebuilders have begun to take some money off the table. That Dow Jones U.S. Home Construction Index, which as noted was up 44.4% over the preceding 12 months, was also down 4.8% in the week ended November 8. It was among the ten worst performing industry sectors last week, even as the broader U.S. Total Market Index was up 0.8% on continued optimism about the prospects for an interim trade deal between the U.S. and China. The Dow Jones U.S. Home Construction Index has now fallen 7.2% since reaching an intraday peak on October 25.
The Lark Research Homebuilder Stock Price Index, which includes 11 publicly-traded builders, has shown the same general trend, but with greater volatility. Since its October 25 peak, the Index is down 9.3%. Last week’s decline was mostly broad-based, but it was noteworthy that the best performer in the group, Toll Brothers, which was down only 2.6%, is also the stock that has most underperformed its peers over the past year.
Last week’s declines came as the yield on the 10-year Treasury jumped 21 basis points to 1.94%. If that yield holds, the average rate on a 30-year mortgage could climb to 3.75%-3.80% next week, the highest level since July. If mortgage rates rise on expected increases in the pace of economic activity, many low-end buyers will likely get squeezed, but activity at the high end of the market could improve.
The gains in homebuilder stock prices accelerated this summer in the face of falling mortgage rates, despite concerns about slowing economic growth. This last leg up certainly looks speculative and it would not be surprising to see the stocks give back a portion of these gains in the weeks ahead. After that, homebuilder stocks could trade sideways as investors seek a clearer direction on the course of the economy and interest rates, especially as year-over-year comparisons in order trends become less favorable in the new year.
Yet, I expect that builders will likely remain optimistic in their sales outlooks going into 2020, as long as economic growth remains at or above the current pace and mortgage rates remain low. In that case, homebuilder stocks will likely advance to new highs eventually after the current correction but before the current economic expansion ends.
November 10, 2019
Stephen P. Percoco
16 W. Elizabeth Avenue, Suite 4
Linden, New Jersey 07036