Homebuilders: A Slump After the Jump?


By Sam Stovall The homebuilding industry has confounded many investors over the past couple of years. This group has outperformed the S&P Composite 1500 index in each of the past four years, posting a five-year compound annual price growth rate of 31%, vs. an annual decrease of 2.5% for the 1500. Year-to-date through Aug. 20, the S&P Homebuilding index is up 2.9%, vs. the S&P 1500's decline of 1.0%, buoyed most recently by an unexpected decline in interest rates.

When will this group's winning ways come to an end? Soon, in our opinion. Take a look at the 52-week relative-strength price chart below, which traces the Homebuilding index's rolling 52-week price performance, vs. the S&P 1500's since the end of 2000, along with the 39-week moving average and overall trend. Three technical factors point to this subindustry's eventual underperformance of the broader market, in our view.

First, the overall trend is lower, as can be seen in the descending black line drawn off the high of December, 2001, and the double top traced out in late 2003 and mid-2004. Next, we see that the relative-strength line broke below its moving average back in April of this year. And finally, we see that the moving average has also trended lower.

However, technicals aren't the only reason to think that this group has seen better days. Michael Jaffe, S&P's Sector Group Head for Industrials & Materials, as well as our homebuilding analyst, believes the fundamental outlook also is negative. He writes: "With the U.S. economy showing some signs of inflation, and the economy likely to grow for an extended period, in our view, we think the Federal Reserve will enact an ongoing series of rate hikes after two increases since June, 2004.

"As of August, 2004, S&P's Economics department expected 30-year mortgage rates to move higher through 2008 but to stay relatively buyer-friendly through that time. Yet, based on our view that we're in the midst of an upturn in rates, we expect the S&P Homebuilding Index to underperform the S&P 1500 over the next year.

"Sales of new single-family, site-built homes were at or near record levels since 1998, aided largely by low mortgage rates. After moving down to 5.4% in March, 2004 (near the 45-year-plus low of 5.3% in June, 2003), rates on 30-year conventional mortgages had risen as high as 6.4% as of mid-June 2004, but subsequently fell to 5.9% as of early August.

SHRINKING FOUNDATION. "Following various pieces of vital economic data, the economy seemed to fall into a bit of lull, especially in the area of June and July labor statistics. Yet, based on our view that the U.S. will see solid, but not extreme, economic growth in coming periods, S&P sees mortgage rates averaging 5.9% in 2004 and 6.4% in 2005, with average annual rates moving sequentially higher to 7.3% in 2008.

"Rates typically have the largest influence of any factor driving home sales, based on their effect on mortgage payments and income needed to obtain a mortgage. Thus, after record industry sales of 1.1 million homes in 2003, we see small gains in 2004, based on our view of relatively low mortgage rates and an ongoing recovery in job markets and consumer confidence.

"Despite our belief that home sales will remain solid in coming periods, and that large builders will post earnings gains through 2005, we see the expected Fed rate-tightening program shrinking valuations for homebuilders. A study by S&P shows that in the six periods of multiple Fed rate hikes since 1973, the S&P Homebuilding index underperformed in the 6- and 12-month periods after the first rate hike. While past performance is not a valid indicator of future returns, we expect this trend to continue in the rate-tightening program that we see in the coming year."

So there you have it. Even though this group has been buoyed recently as a result of the decline in the yield on the 10-year Treasury note from investors' increased skepticism over the health of the U.S. economy, we continue to see the U.S. economy expanding over the next two years. As a result, we expect the yield on the 10-year T-note to resume its uphill climb and assist in depressing the share prices for the homebuilders.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), their proxies (the highest STARS-ranked companies in the subindustry index-tie goes to the largest market value) as of Aug. 20, 2004.

Industry

Company

Ticker

STARS

Recent Price

Consumer Electronics

Harman Electronics

HAR

5

$94

Diversified Metals & Mining

Peabody Energy

BTU

4

$54

Fertilizers & Agricultural Chemicals

Scott's Co.

SMG

4

$57

Homebuilding

Pulte Homes

PHM

3

$59

Internet Retail

eBay

EBAY

5

$81

Internet Software & Services

Yahoo

YHOO

3

$29

Multi-Sector Holdings

Leucadia National

LUK

Not Ranked

$51

Office Electronics

Xerox

XRX

3

$14

Oil & Gas Refining & Marketing & Transportation

Premcor

PCO

5

$33

Steel

Nucor

NUE

3

$84

Tires & Rubber

Cooper Tire

CTB

3

$23

Wireless Telecommunication Services

Nextel Partners

NXTP

5

$15

Required Disclosures

Standard & Poor's Stock Appreciation Ranking System (STARS)

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate that of the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of June 30, 2004, SPIAS and their research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings, and 11.4% with sell ratings.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company. SPIAS is affiliated with other entities, which may receive compensation for performing services for companies covered by Standard & Poor's Equity Research Services.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions, and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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