Home Builder Stocks for the Long Run?

September 23, 2008


The first investment book I ever read was called “Stocks for the Long Run”, by Jeremy Siegel, back in 1997.  I borrowed the title from that book to kick off this study of the Home Builder stocks. 


We are still getting hit with a lot of housing-related data each month.  Existing home sales are very low, but have stabilized at around 5 million per month over the past 6 months.  The months of supply on the market is also stabilizing around 11 months.  While these are still at historic extremes, the bleeding has at least been stopped:  the Home Builder stocks are starting to reflect Relative Strength.  To investigate how the housing cycle compares to the stock market, via the Residential Construction Index (RCI, an index of home builders such as Beazer, Pulte, etc.), I went back to the 1998-2003 business cycle.  Here is the chart:


Figure 1

Residential Construction VS. The S&P 500, 1998-2003


Starting from the left of the chart, we see that housing and the market peaked in mid-1998.  There was a tremendous sell-off that fall, from which the market quickly recovered.  However, home building stocks did not come back, and eventually bottomed out in early 2000, just as the market was topping. 


When housing stocks bottomed, they retested a recent low (late 1999), and bounced from there.  Interest rates were very low under Alan Greenspan, and the housing bubble was born.  The time from the peak of housing stocks to the peak of the market was 20 months.  This is also, somewhat by coincidence, the same time that the housing stocks took to drop nearly 50% to their ultimate bottom.


Finally, the green line in the bottom pane is the ratio of the RCI to the S&P500.  A rising RS line indicates that the RCI is outperforming the overall market.  Conversely, while the green line is going down, housing stocks are underperforming the market, as in 1998-2000.


Now, let’s turn to our current chart:

Figure 2

Residential Construction VS. The S&P 500, 2005-2008


This time around, the housing stocks peaked in mid-2005.  Twenty-seven months later, the general stock market peaked.  Shortly after the market peak, the RCI stabilized, in late 2007, to a sort of sideways movement.  The decline of 71% vs. the 50% decline in the 1998-2000 may be explained by the excessive run-up prior to the 2005 peak.  This is the so-called Housing Bubble that we are still paying for.


As you can clearly see, the period from October 2007 through today shows the market down well over 20%, but the RCI has remained relatively flat.  Relative Strength, the green line, has been trending sideways to slightly higher, just as it did in the first half of 2000 in Figure 1. 


The similarities are many, and have convinced me that if you are a long-term investor, you may want to consider scaling into the home builders.  The vehicles I use are the XHB and URE ETFs.  I strongly advise the use of ETFs to avoid individual company risk.  The XHB is the standard ETF for Residential Construction, while the URE is an Ultra 2x movement to the XHB.  Just like the 2 ETF I discussed previously for the financials (XLF, UYG), the URE will swing at twice the percentage gain of the XHB.


Speaking of the Financials…

There have been a lot of changes, panics, government regulation, and general uncertainty surrounding the financial stocks.  The XLF and UYG are very close to the same level they were in July when I first wrote about them.  They have been volatile, but have not broken out of their 3 month range:



However, if you decided to pick individual stocks, your results could be very mixed.  Lehman Brothers is out of business, AIG dropped 80%:



Two of the most respected Investment Banks in the market were Goldman Sachs and Morgan Stanley:  They have had a wild ride, and have since transformed into Holding Banks, rather than Investment Banks (read:  more regulation, less leverage, access to discount window):




On the other hand, JPMorgan Chase has done well since July:




My point is that when there is a significant chance of a few companies to report huge losses, in an otherwise rebounding industry, the ETFs are the way to go.


Take care,

Dan Grill