Higher Rates Make for A Slippery Bottom for Housing Stocks

By Dr. Duru written for One-Twenty

March 6, 2006

The bond market may finally be waking up to the prospect of higher interest rates (higher inflation and/or a more aggressive Fed). On Friday, the bond market sent the 10-year Treasury to levels not seen since 2004, and the market's "reaction" reminded me of the angst from December when rates were last around these levels. The chart below tells the current story:

10-year bond since 1995

What told me that the market may finally be ready to take higher rates seriously is that several homebuilder stocks seriously stumbled at the same time. Higher rates are perhaps the biggest threat to the thesis of a bottom in homebuilder stocks. And I am not even talking about the current levels of rates. I am talking about the market's perspective on where rates are likely going. Right now, we are back in an area that rates have failed 4 times previously to break. If the 10-year treasury finally breaks out, all bets are off on how high rates can go. The longer-term chart suggests that 5% would be the next logical place to stall out. A break above that should really set off the bond world's alarm bells.

Higher interest rates imperil the housing market, and the homebuilder stocks in particular, because they increase the cost of borrowing. Given that homes in many desnely populated, mainly coastal, areas are unaffordable and homes in general are very expensive for the average family, higher rates will drive demand down even further for homes and will eventually pressure prices downward. From my reading and listening to earnings reports and the commentary of housing bulls, this kind of scenario has not been included in the equation. So, if the market begins to believe that a new upward trend in rates is upon us, I expect the homebuilder stocks to violate their current bottoms faster than you can say "sell the bubble." But if the longer-term downtrend in rates remains intact, I would begin loading up on the homebuidler stocks (assuming no other variables have changed the risk/reward).

Instead of posting charts of the various homebuilder stocks that I follow, I will just present a summary of where I think they are in relation to their presumed bottoms (click here for disclaimer):
  1. Beazer Homes (BZH): one of the most "dangerous" charts around. Broke February's low only to bounce back sharply and now sits precariously right on top of the 200DMA. The chart sure looks like a burst bubble in action. BZH could be the first bottom-breaker and could signal a renewal of pain to come for homebuilder stocks!
  2. Centex (CTX): remains the strongest of the bunch. Long-term up-trend still intact.
  3. Kb Home (KBH): had one of the worst tumbles on Friday - a drop of 2%. February's lows and the presumed bottom are pennies away. Next support is about 10% away...and then things really get ugly. I saw no company-specific news, but earnings are coming up in 3 weeks. Should we be worried?
  4. Hovanian (HOV): in a similar situation as KBH. The market tried to put a good face on Thursday morning's earnings conference call, but the heavy selling on Friday following a downgrade from JMP Securities reveal true sentiment with a quickness. Apparently JMP expects declining earnings for the next two years.
  5. Lennar (LEN): listless stock. This one is stuck in a trading range although a longer-term up-trend is still in play. Bottom of the trading range is nowhere in sight yet.
  6. Meritage Homes(MTH): Now that TOL has "bottomed" MTH really stands out as the ugly-duckling of the bunch. A downtrend from 2005's peak is firmly in place, and the stock is right back at a bottom that has been tested numerous times in the past year. Such a line can only withstand so many hits. If this line finally does break soon, watch out...
  7. Pulte Homes (PHM): bottom still a point and a half away and stock remains listless
  8. Ryland Group (RYL): similar to PHM
  9. Toll Brothers (TOL): the most defiant of the bunch now. After being incessantly beaten to a pulp, it looks like the sellers have finalyl finished for now. The February lows have been left far behind but BIG resistance lies overhead in the form of the 50DMA and the neckline of a head & shoulders pattern. Go above $34 or $35, and we should assume that the rich will prevail in any coming housing storm. (Recall that Toll focuses on the upper-end of the market).
Finally, the Wall Street Journal has a very interesting article in today's edition called "Buying the Returned Home: As More People Walk Away From Contracts, Some Builders Cut Prices; How to Spot Deals." Author Ruth Simon describes the increasing cancellation rates in the housing industry and the various sales, promotions, and incentives some homebuilders have to use to clear out this increasing inventory of unsold homes. Two common themes seem to be at work: speculators are finally getting cold feet as a top in prices looms and folks who are trying to upgrade are having trouble selling their old homes. An uptrend in interest rates will of course transform these cancellations from spring showers to a wintry torrential downpour...

As always, be careful out there!

DrDuru, 2006