Last week, in the midst of a generally positive week for economic data and earnings, investors received a bit of a shock on the home data front.

Investors digested news that existing home sales slipped in March to their lowest since July 2012. In addition, the U.S. Census Bureau reported that new home sales collapsed to a seasonally adjusted annual rate of 384k from 449k in February, the biggest monthly drop since last summer.

Despite pending home sales data earlier this week that came in better than economists’ estimates, the magnitude of last week’s home sales drop, coupled with concerns over affordability and rising rates, have many wondering if last year’s housing rebound is already fizzling.

While I would agree that higher rates and rising prices are likely to slow future home sales gains, I still believe housing will be additive to the U.S. recovery in 2014 for two reasons.

  1. March’s print may have been distorted by last winter’s unusually cold weather. More recent economic data has generally been coming in at, or above, expectations.
  2. While higher mortgage rates are likely to slow housing activity, overall affordability remains reasonable and credit conditions are loosening. While down substantially from the 2011 peak, housing affordability is still significantly above the 25-year average.

That said, even if the housing market continues to heal, an improving housing market doesn’t necessarily translate into a profitable investment thesis for homebuilding stocks. Despite the recovery in housing, I’ve been cautious on the homebuilding industry for some time.

The stocks, as measured by the S&P 500 Homebuilders Select Industry Index, underperformed the broader market significantly in 2013, rising roughly 12% versus a 30% gain for the broader market, as measured by the S&P 500 Index. Year-to-date, despite falling interest rates, which generally support the industry, homebuilders are down more than 5%.

In my view, homebuilding stocks have struggled for two reasons: stretched valuations and vulnerability to rising real rates.

While valuation is less of an issue today, the stocks are not so cheap as to be unaffected should rates start to rise again. Historically, homebuilding stocks have traded at around a 45% discount to the broader market. This discount reflects the very cyclical nature of the business and the volatility of the earnings stream.

However, by early 2013, optimism over a housing recovery pushed valuations to a 14% premium to the broader market. This left the stocks exposed when rates started to rise last spring. While valuations have come in considerably – the industry now trades at a 35% discount to the market (using the same indices for measurement as I mention above) – the stocks are still not particularly cheap.

If real interest rates start to rise again, as I expect they will, these stocks should be more vulnerable than most sectors. In the past, the level of real long-term interest rates has explained roughly 60% of the variation of the homebuilder industry’s value relative to the broader market (see the chart below). In other words, when and if real rates start to rise, the industry’s valuations may not provide enough of a cushion. For now, I’d look for an even bigger discount before recommitting to this sector.

chart

Sources: Bloomberg, BlackRock research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.

Funds that concentrate investments in a single sector will be more susceptible to factors affecting that sector and more volatile than funds that invest in many different sectors.

iS-12346

?feed-stats-post-id=18036

Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

Related Articles
  1. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  2. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  3. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  4. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  5. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  6. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  7. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  8. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  9. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  10. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
RELATED FAQS
  1. Does an FHA loan require a down payment?

    Federal Housing Administration (FHA) loans require down payments, which can be as low as 3.5% of the total purchase price ... Read Full Answer >>
  2. Do FHA loans have closing costs?

    Because Federal Housing Administration (FHA) loans are provided by financial institutions, taking out an FHA loan entails ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center