At Long Last, Sustained Signs of a Housing Rebound

Each new week, it seems, brings more good news to the beleaguered United States housing sector, in the form of a wave of economic reports showing improving housing prices and growing numbers of housing starts. Most recently, the S&P/Case-Shiller 20-City Composite Index showed rising U.S. home prices again during the month of July. For four consecutive months now, home prices broadly have risen, and for three straight months, every one of the 20 cities included in that index registered housing price increases.

At the start of the year, Morningstar's director of economic analysis Bob Johnson, CFA, made the case that the housing market would see "meaningful improvement" in 2012, although he cautioned, "it might be a second-half story." The growing numbers of positive reports on housing suggest that that is precisely how the housing story is playing out. More recently, Bob has stated that "the strength in the housing recovery has been building for most of 2012 but has yet to have much of an impact on overall economic activity. I think that will change in the second half as existing homes purchased in the first half are remodeled and furnished."

Now, a consensus has formed among economists that the housing sector, which previously during the recovery has seen prices rise in fits and starts only to fall back to new lows, is in the midst of a sustained recovery at long last. Economists and analysts have noted a raft of positive data coming in in recent months across all areas of the housing sector, including rising sales of existing homes, fewer house foreclosures, rising sales of existing homes, and improved activity in new home construction, in the form of strong housing start numbers.

As is often the case, investors saw the improving signs in the housing sector well before the numbers were posted, with investors bidding up the shares of all homebuilding stocks far in excess of the broader market. For example,  DR Horton (DHI) has returned 73% since the start of the year, while  Lennar Corporation (LEN) has returned 85%,  M.D.C. Holdings  has returned a jaw-dropping 129%, and PulteGroup (PHM) has returned a stupefying 154%.

As homebuilders' shares have surged, investors should review their own margins of safety to determine whether homebuilding companies have more value left in them. For those interested in investing in the homebuilding sector, an exchange-traded fund is an ideal way to hold a broad basket of the U.S.' largest homebuilders. For such investors,  iShares Dow Jones U.S. Home Construction (ITB) likely is the best option. The fund is suitable only as a complementary satellite holding in a diversified portfolio. The average market capitalization of a company in ITB is about $4 billion. Investors should take note that the housing sector is highly cyclical and quite sensitive to economic and credit conditions.

Aside from homebuilders (which account for about 65% of total assets), this fund also holds building-materials and fixtures producers (17%), home-improvement retailers (13%), and furniture companies (5%). This fund contains 27 companies and is fairly top-heavy, with the top-10 holdings accounting for more than 64% of total assets.

Fundamental View
The bursting of the housing bubble, the accompanying credit crisis, and the economic downturn have devastated homebuilders and the broader housing industry. Although all the recent positive data would suggest the sky's the limit for homebuilders, there's always a risk of frothy valuations. Plus, despite all the rosy data and mortgage rates remaining at record lows, there are some danger signs that could hamper homebuilders going forward, such as a huge inventory of foreclosed homes on the market at distressed prices and lending standards much tighter than a few years ago. Given the lousy job market, high housing inventory, and a sea of foreclosures, it's reasonable for an investor to wonder whether homebuilding stocks have gotten ahead of themselves, given their recent rally.

By aggressively reducing inventory and ratcheting back on developments, many of the large homebuilders now are sitting on piles of cash, despite the heavy losses they have taken in recent years. They have also downsized their organizations to better align their cost structures for a lower-demand environment. During the past few years of weakness, many private homebuilding companies have gone bust, and even the stronger publicly traded firms have written off half or more of their book equity since the peak. But the homebuilders that survived are now standing on more-stable financial ground. Thanks to stimulus-related initiatives from 2009, such as the first-time homebuyers credit and longer tax-loss carrybacks for U.S. corporations, homebuilders have been able to improve their businesses and their balance sheets over the past few years.

One possible catalyst for the housing sector involves further quantitative easing, known as QE3. On Sept. 13, the Fed announced its plans to purchase $40 billion of agency mortgage-backed securities per month and extended its pledge to keep short-term rates pegged at zero until mid-2015. What is unique about QE3 is that it is open-ended. The Fed plans to keep buying MBS until the economic recovery is well established. This seems like a no-lose situation for housing prices. If the Fed's actions are successful and the labor market improves, it will likely result in improved consumer confidence and higher home prices. If their actions are unsuccessful, they will likely spur inflation, which may also support housing prices. In the wake of the Fed announcement, 30-year mortgage rates hit historic lows of 3.4% and are likely to continue moving lower as the Fed ramps up its purchases. Low rates could provide further stimulus for homebuilders.

While Morningstar's equity analysts don't cover enough stocks in this ETF to form a fair value opinion, we can get some idea about valuation by looking at the individual stocks they do cover, including DR Horton, Lennar,  Toll Brothers (TOL), and  NVR (NVR). Unfortunately, each of these stocks looks overvalued, particularly Toll Brothers, which is trading at its Consider Selling price of $35.70.

Portfolio Construction
This fund aims to replicate the performance of the Dow Jones U.S. Select Home Construction Index. The index contains 27 companies, and holdings are float-adjusted and market-cap-weighted. However, total holdings in non-homebuilding companies are capped at a maximum of 40% of the portfolio. Out of 27 companies in the fund, 12 are homebuilders. The largest non-homebuilding holdings are home-improvement retailers  Home Depot (HD) (5%) and  Lowe's (LOW) (4%) and building materials manufacturers  Sherwin-Williams Co. (SHW) (3%) and  Masco (MAS) (3%). The fund is fairly top-heavy, with the top-10 holdings accounting for more than 64% in total assets.

Fees
The fund's 0.47% annual management fee is slightly higher than  SPDR S&P Homebuilders (XHB), which is a similar ETF. XHB charges 0.35%.

Alternatives
The only other homebuilding ETF of any significance is the cheaper (0.35% expense ratio) SPDR S&P Homebuilders(). ITB and XHB both are focused on the homebuilding industry, but they follow very different indexes. The index tracked by ITB, the Dow Jones U.S. Select Home Construction Index, is a float-adjusted market-capitalization index, and caps total non-homebuilding holdings to a maximum of 40%. XHB tracks the S&P Homebuilders Select Industry Index, which is an adjusted equal-weighted index. Because of these differences, ITB has a much higher exposure to homebuilders, at more than 65% of the portfolio. XHB, on the other hand, has only about 28% of its portfolio invested in homebuilding companies. ITB trades about 1.8 million shares a day and is far less liquid than the highly liquid XHB, which trades about 6.5 million shares a day. Despite some obvious differences between the two funds involving the respective sizes of direct investments in homebuilding companies, the performance of XHB and ITB is 97% correlated over the past five years.

 

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