by Zach Scheidt, Investment U Research
Friday, June 28, 2013
Stock prices for major U.S. homebuilders are under pressure as investors worry about higher interest rates. If you’re invested in these stocks, you should worry, too.
Fed Chairman Ben Bernanke indicated recently that the Fed will soon begin to reduce its $85 billion-a-month bond purchases, and end them all together by the middle of next year. The news sent shivers through the bond market, driving prices lower and pushing interest rates higher.
Higher mortgage rates clearly spell trouble for homebuilders. Homebuilder stocks have already started to decline in response to these higher rates, but they could have much further to fall. Let’s take a look at how vulnerable this group could be.
Panic in the Bond Market
To understand how the Fed’s actions could dramatically affect the homebuilder sector, we first need to understand the magnitude of the Fed’s influence on the bond market.
The artificial demand for Treasury bonds and mortgage-backed securities created by the Fed has propped up prices – and by definition, higher bond prices equates to lower interest rates.
Not only has the Fed been buying bonds, but the $85 billion monthly commitment has influenced other money managers to step in and buy these bonds as well. It makes sense for institutional investors to buy “safe” assets when the Fed has publicly implied that it will do what is necessary to support prices for these assets.
If you’re an institutional investor, whose job is tied directly to the performance of the securities you own, and you hear that the Fed – your strongest ally up to this point – is now pulling out of the market, what are you going to do?
At the very least, you are going to reduce the amount of new capital that you invest in Treasurys or mortgage-backed securities. And many of these managers are selling positions rather than waiting to see how far bond prices will fall.
According to the latest reports from Freddie Mac and Fannie Mae, yields on mortgage bonds have now reached their highest level since August of 2011. And this has happened before the Fed has done anything! All that has happened so far is that the Fed has announced that it might reduce its level of purchases later this year. Imagine what could happen once the Fed actually implements these new initiatives.
Trouble for Homebuilders
It doesn’t take too much imagination to realize how higher interest rates affect homebuilders. The industry is just getting back to a profitable state, after suffering huge losses in the wake of the collapse of the housing bubble.
Today, homebuilders are finally getting back to their old ways:
- Buying large tracts of property.
- Investing hundreds of millions in developing new communities.
- Building “spec” houses in anticipation of new demand.
All of this just in time for a rate spike that figures to dramatically reduce demand for new homes.
And if the interest rates weren’t bad enough, two other issues present significant challenges for the homebuilder sector.
- Employment is weaker than you think. Sure, the unemployment rate has been slowly declining for the last few years. But the quality of the new jobs being created is much lower than the quality of jobs that were lost, and wages are lower. The New York Times refers to this phenomenon as “the hollowing out of the work force.” Highly paid professionals are still pulling in very attractive salaries. And there are now jobs available for food service workers and other low-paying positions. But jobs for middle class workers are very hard to find.
- Rental rates are dropping in many major real estate markets. Rents had been increasing for several years because of demand from individuals who couldn’t qualify for a home purchase, making homebuying (for those who can qualify) more sensible. But private equity companies have spent billions buying up distressed properties, renovating them and leasing them. There is now a glut of rental properties on the market in many cities, depressing rents. The equation changes for prospective buyers as rents get cheaper and mortgage rates go higher.
Ancillary Businesses Also Affected
Investors should also be aware of the trickle-down effect that higher mortgage rates will have on industries that are directly connected to the housing sector. Specifically, I’m watching stocks like Home Depot (NYSE: HD), Lowe’s (NYSE: LOW), Williams-Sonoma (NYSE: WSM), Pier 1 Imports (NYSE: PIR), and other home renovation/decor companies.
If you’ve ever moved into a new home, you know that there are a myriad of shelves to be hung, furniture to be purchased, pictures and curtains to be hung, and more. There is a thriving industry built around consumers who are moving into new houses and “settling in.” (Not to mention the fact that Home Depot and Lowe’s have institutional contracts with most of the contractors engaged in building the homes).
The majority of these stocks connected to the homebuilding industry have rallied sharply over the last few quarters. You can find a good list of these companies by looking at the holdings of the SPDR S&P Homebuilders (XHB) ETF. Morningstar also has a helpful starting list of these stocks. Investor sentiment has been strong, but is now shifting due to the domino effect stemming from the Fed’s bond purchase decisions.
Take a careful look at your portfolio to see what stocks might be affected by a decline in the homebuilding industry. Consider buying puts or selling short in order to profit from a decline in homebuilder stocks and other stocks directly related to this industry.