The Big Run in Homebuilder Stocks May Soon Be Over

The big rally in homebuilder stocks may soon be over, as evidenced by a decline in the March National Association of Home Builders/Wells Fargo Housing Market Index published on Tuesday.

The HBI, which surveys the current sales conditions, sales expectations and buyer traffic, dropped 2 points to 82 in March.

Homebuilders have staged a big rally over the past 12 months, outperforming the S&P500 by a significant margin (see table).

The run-up in homebuilder shares during the Covid-19 recession may have come as a surprise to some. Homebuilding is a highly cyclical sector, usually suffering during recessions, together with home improvements and other discretionary items.

But the Covid-19 recession wasn't normal. Fiscal and monetary spending helped households maintain their purchasing power, increase savings and search for rural homes to escape from city life, which lost its appeal during the pandemic.

Sales of new U.S. single-family homes rose 4.3% to a seasonally adjusted annual rate of 923,000 in January, ahead of market expectations.

The post-Covid-19 economic recovery won't be normal either. It will redirect consumer demand to things households missed during the lockdowns, like dining out, traveling and, perhaps, bringing back the appeal of city life.

Meanwhile, homebuilders face headwinds like higher long-term interest rates, including mortgages. According to Freddie Mac, the average interest rate on a 30-year mortgage was 3.05% last week—a near half-point higher from the previous year's level. And it could head even higher as the 30-year Treasury bond, a benchmark for long-term interest rates, has been climbing in recent months.

Then there's the problem of affordability. According to data published by ATTOM Data Solutions at the end of December, the median home prices of single-family homes and condos in the fourth quarter of 2020 were less affordable than historical averages in 55% of counties with enough data to analyze, up from 43% a year ago and 33% three years ago.

Simply put, the average income growth has lagged far below the increase in home prices, making it more difficult for buyers to afford purchasing a home. And the situation could worsen as long-term interest rates climb, raising the cost of financing home purchases.

Still, there are rising material costs, which boost construction costs. Plywood, steel and copper prices have skyrocketed in recent months due to supply bottlenecks and increasing demand for these materials.

The bottom line is homebuilders may soon be caught between rising costs and softer demand, meaning lower profit margins.

Wall Street wouldn't like that situation as it would put a stop to the homebuilder rally.

Disclosure: No positions.

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