Can Homebuilder Stocks Build on Their Huge Rally?

Investors are coming out of the woodwork to cause a rally in shares of homebuilder stocks. This beaten-down sector got a sudden jolt of investor attention, as many are now betting that the Federal Reserve will soon lower interest rates. Lower rates, it stands to reason, help sell more homes as cheaper financing costs could boost builders’ margins and attract buyers. But it may take more than a rumored rate cut to push this industry back onto its foundation.

Industry sentiment is worsening, which suggests the rally may be premature. Despite a move lower, high mortgage rates continue to deter buyers, and the supply of homes for sale is growing. As for profits, builders’ margins could be at risk as they have begun to offer incentives to boost sales.

Rallying on Rate Cut Hopes 

Optimistic share purchases of home construction companies rose suddenly after a softer-than-expected inflation report in June. The SPDR S&P Homebuilders ETF (XHB) and the iShares U.S. Home Construction ETF (ITB) both jumped nearly 6% on Tuesday, with XHB reaching a record high. This rally reflects investor bets on a Fed rate cut in September, which could make mortgages cheaper and boost demand for new homes. While the current market sentiment is that a cut of 0.25% is a sure thing, nothing is a sure thing, especially around an election.

Groundbreaking Shift in Sentiment 

This sudden U-turn in homebuilder stocks is not supported by most fundamentals. Homebuilders are still struggling because of heightened mortgage rates and buyer hesitation. There is typically a long lead time in the business cycle as well. If and when things do head upward, it takes a long time from the drawing board to the closing table. Analysts like BTIG’s Carl Reichardt Jr. point out, “The shift in narrative that seemed to be impacting the stocks was just so suddenly changed.”

Mortgage Rates Closer to Ceiling Than Basement

Recent mortgage rate declines are unlikely to significantly impact affordability in the near term. Analysts believe rates need to fall into the high 5% to low 6% range to meaningfully attract buyers back to the market. Currently, 30-year fixed mortgages sit around 6.84%. 

While lower rates would be a positive long-term factor, Wedbush analyst Jay McCanless cautions that the core issues plaguing the sector haven’t vanished. Homebuyers are still cost-conscious, especially with high mortgage rates. Additionally, a growing housing supply and potential margin pressure due to buyer incentives create further challenges. 

High mortgage rates force builders to offer attractive incentives or lower prices to entice buyers. This puts pressure on their margins, as McCanless highlights, “Margin estimates are probably still a little high for the group.” 

In fact, the National Association of Home Builders’ (NAHB) July survey revealed that 31% of builders lowered prices to boost sales, and over 60% continue to offer incentives. Furthermore, the NAHB builder sentiment index dipped to 42 in July, indicating pessimism within the industry. 

In addition, upcoming earnings reports from major builders like D.R. Horton (DHI) could impact investor sentiment, as disappointing earnings reports could dampen the current rally. 

Key Takeaway – Significant Challenges Remain 

While a Fed pivot could eventually benefit homebuilders, significant challenges remain. Investors should wait for upcoming economic data and earnings reports before jumping into the sector based solely on the hopes of a rate cut. While the idea of a Fed pivot has fueled the recent rally, investors should remain cautious. The problems facing the home building industry have not gone away, and it may make sense to wait for more information before jumping into the sector.