Homebuilder Fundamentals Deteriorating – Stocks At Risk

The underlying fundamentals of residential construction (AKA homebuilding) have weakened. And yet the stocks have strengthened. So, which is correct?

Normally, the stock market is viewed as the leading indicator. However, there are times, like now, when the stock investors get carried away with wishful thinking as I described in my previous article.

Therefore, focusing on these key fundamentals now is the best approach.

Mortgage interest rate and median new home price trend

Because most homebuyers rely on mortgages, the interest rate is a key determinant of how high a home price they can afford to pay. The green line in the graph below shows a high 6% to 7% range has established itself.

The effect is showing up in the median new home prices (orange line) that are now in a downtrend. While stock investors like buying on the dip, many new homebuyers are encouraged by a home price uptrend.

So, both the high mortgage interest rate and new home price downtrend are negative homebuilding fundamentals.

Homebuilder attitudes

The NAHB (National Association of Homebuilders) has surveyed homebuilder attitudes for many years. Three questions are asked: How are present conditions? What is your outlook? What is the homebuyer traffic like?

The graph below shows the overall index for the past four years. The orange line shows the first six months of 2023. While it is in an uptrend, it started at a low level and has not reached an optimistic height like in 2021.

So, homebuilders are mainly showing relief that this year’s sales have not been affected by the high mortgage interest rates as much as they feared earlier. Nevertheless, “relief” is not an especially positive outlook.

New home sales and the inventory of homes for sale

New home sales are obviously an important measure of homebuyer interest. However, homebuilder health and optimism rely on maintaining a proper level of homes for sale. By watching the relationship of the two measures, we can better understand the state of the new home market.

Start with this graph that shows the history of the two measures. Importantly, notice the seasonal volatility the homebuilders must contend with. Then look at the recessionary periods. Depending on the cause of the recession, new home inventories can suddenly rise as new home sales drop. That pattern is especially noticeable leading up to the Great Recession, when the housing boom collapsed.

Now look at the recent period in the next graph. The unexpected good sales in 2020 resulted from the Federal Reserve-driven low mortgage interest rates and enormous expansion of the money supply. Those happy days carried over to 2021. (Hence, the homebuilder optimism shown above.)

Then came the Fed’s 2022-current inflation fight using higher interest rates. The graph highlights the usual peak and trough quarters of new home sales and shows how they became skewed in 2020 and 2021. And now we see the warning sign – the second quarter of 2023 peaked at the 2019 level. What comes next is the seasonal slowdowns. And yet the inventory of homes is well above its normal relationship to sales currently. That necessarily indicates a slowdown of construction is at hand, both for the seasonal drop in sales and to correct the inventory excess.

Homebuilder stock performance

Now look at what investors have been up to. In their search for stocks that could go up, they have mistakenly looked back instead of forward. Hence, the good performance from past winners. Clearly, the fundamental issues above are being ignored or dismissed as the stock prices go up. But that simply raises the risk of owning homebuilder stocks (and other has-been stocks that have been bid up recently).

The bottom line – The stock market isn’t always prescient

The mismatched homebuilder stock performance and homebuilding fundamentals is a good example of investors going off-road. Fun while it lasts, but fundamentals win in the end.