Why the Collapse of Housing Stocks May Get Worse

Rising interest rates on mortgage loans are deterring home buyers, and that has translated into plunging sales, earnings and stock prices for the homebuilding industry, an important engine of economic growth. Mark Zandi, chief economist at Moody's Analytics, had this to say, as quoted by CNBC: "Every basis point rate rise already is affecting housing. The run-up in rates over the past year is now weighing increasingly heavily on single-family housing demand, particularly since housing prices have risen so much. Affordability is now an issue for many potential home owners."

A number of stocks in homebuilding and related industries are in a bear market of their own, having plunged by 20% or more from their 52-week highs. Among these are Lennar Corp. (LEN), D.R. Horton Inc. (DHI), PulteGroup Inc. (PHM), LGI Homes Inc. (LGIH), Toll Brothers Inc. (TOL) and lumber supplier Weyerhaeuser Co. (WY). The table below shows how far these stocks have dropped.

Housing Stocks Could Plunge Even Further

Source: Yahoo Finance, as of the close on Oct. 11.

What Matters for Investors

The average rate on 30-year fixed rate home mortgages, a key benchmark for home buyers' financing costs, is now above 5% for the first time since April 2011, per Bankrate.com. This is up by more than 100 basis points (bp) from a year ago, and by more than 150 bp from 2016, according to data from Mortgage News Daily (MND), as cited in another CNBC story. As Matthew Graham, the CEO of MND, told CNBC, "Five percent is definitely an emotional level inasmuch as it scares prospective buyers about how high rates may continue to go." (For more, see also: Why Housing Market Bubbles Pop.)

On a $300,000 loan, a rise of one percentage point, or 100 bp, to the interest rate adds $250 to the monthly cost. The added financing cost discourages potential borrowers and causes lenders to reject more applicants, given a higher ratio of prospective debt service to income, CNBC notes. The table below illustrates how badly homebuilding stocks have lagged the market in the face of rising interest rates this year.

Housing Stocks Missed The 2018 Rally

Sources: Yahoo Finance, S&P Dow Jones Indices; through the Oct. 11 close.

In addition to homebuilding stocks, the S&P Homebuilders Select Industry Index includes building products, home furnishings, household appliances and home improvement retailing stocks. Several ETFs, including the SPDR in the table above, are designed to track this index and deliver similar total returns.

Recent softness in the housing market includes sales of existing homes as well as those of newly-constructed dwellings. Sales of existing homes have declined on a year-over-year (YOY) basis for 7 of the first 8 months of 2018, per the National Association of Realtors (NAR). The median sales price of existing homes, meanwhile, has increased by roughly 5% YOY, per the NAR data.

Susan Maklari, an analyst at Credit Suisse, told CNBC that the slowdown in home sales is most evident in the most expensive end of the market. "When rates rise, people might respond by purchasing homes that aren't as expensive," observed Ben Herzon, an economist at Macroeconomic Advisers, in remarks to CNBC. However, the NAR data on sales of existing homes indicates that those worth $1 million or more have enjoyed the biggest percentage sales increase from a year ago, at 11.8%, while the cheapest homes, those valued at under $100,000, have seen an 11.9% drop.

Maklari indicated that the strength of the housing market varies regionally, and the regional breakdown of sales by homebuilding companies reflects this variation. Areas of the country that are enjoying population and employment growth, such as Texas and elsewhere in the south, are producing brisk sales. Higher cost states such as California, meanwhile, are experiencing slowdowns in population and job growth, leading to declining sales growth, if not absolute sales declines.

Looking Ahead

"There are other factors, in addition to rates, that affect housing—how well income is doing, whether people have jobs," economist Ben Herzon noted. With the Federal Reserve having signaled its intent to continue raising interest rates, thus increasing the odds that the economic expansion will stall and eventually turn to recession, the rough patch for homebuilding stocks is likely to continue. Morgan Stanley believes that "growth has peaked for the cycle," and that a stock market correction is becoming more likely. (For more, see also: 'Exuberant' Market Faces Second 10% Reversal Since January.)

On the other hand, the experts cited by CNBC have optimistic outlooks. Herzon said that his firm is forecasting "continued improvement in the housing market, at least for the next couple of years." He indicated that home price increases have slowed, but he does not anticipate a significant slowdown in the housing market overall. Meanwhile, despite their recent plunges, analyst Susan Maklari of Credit Suisse has outperform ratings on Lennar, PulteGroup and D.R. Horton, based on upbeat sales forecasts. Nonetheless, she added that homebuilding stocks are undergoing a "compression" of their valuation multiples, even when earnings estimates are revised upward.