What Are the Declining Homebuilder Stocks Trying to Tell Us?

By Sasha Cekerevac

One of the few positive sectors within our economy over the past year has been the housing market. Even though economic growth overall has been less than optimal, the housing market rebound has certainly helped improve the overall situation.

With comments by the Federal Reserve that they’re preparing to reduce their monthly asset purchase program, investors reacted abruptly and sent interest rates shooting up over a very short period.

Over the past few weeks, rates from 15-year to 30-year mortgages have gone up approximately 0.5%. Can the housing market sustain its growth trajectory in the face of higher mortgage rates?

Historically speaking, we are still at very low levels when it comes to mortgage rates. However, the psychological affect of the rapid rise might begin to become a slight drag on economic growth.

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The housing market comprises many variables, and interest rates are just one of them. Incomes, we know, are not rising rapidly, but the housing market inventory is extremely tight. That dichotomy has been bullish for home prices so far, but at some point, higher interest rates will begin to become a larger factor.

Because the overall economic growth of America is still relatively weak, if rates continue rising, this would have an impact on the housing market.

Markets react far quicker than policymakers. When market participants think an event will occur, they will quickly rush to adjust their positions. Since shifts in policy will occur only when the data improves, this too is a double-edged sword.

If economic growth really does begin to improve, along with it will come higher levels of income. That will partially offset the higher mortgage rates, creating an entirely different dichotomy for the housing market.

Historically, mortgage interest rates are still very low; at this point, we should not worry too much about a significant decrease in demand in the housing market. In fact, prices have begun rising too fast in certain markets, as the latest S&P/Case-Shiller report noted a more than 12% year-over-year price increase nationwide.

One of the problems leading to the crash last decade was the over-exuberant speculation in the housing market. Economic growth needs to be built on a solid foundation, not one in which homeowners are speculating in the housing market to try to become rich.

Of course, that goes hand-in-hand with much-needed tougher regulation to prevent those who cannot afford homes from being active speculators in the housing market.

Chart courtesy of www.StockCharts.com

One thing that I’ve been discussing recently has been the overvaluation of many homebuilder stocks. Even though the housing market is continuing to rebound, homebuilder stocks have priced in most of the good news over the next couple of years.

That is assuming that everything goes perfectly, without too much economic growth to raise rates and begin curtailing the rebound in the housing market. I think it is far more likely that we get back to a more normal housing market, which means that many of the homebuilder stocks are, in my opinion, overvalued at current levels.

It’s one thing to buy a home; it’s quite another to invest in a homebuilder stock. As an investor, you are discounting forward revenue and earnings in incorporating those figures into the current valuation. That assumes a lot of variables, most of which I believe are far too optimistic.

The homebuilders have performed extremely well on the back of the rebound in the housing market, even though economic growth has been relatively anemic. Considering the huge return since 2009, I think there is far more downside risks than upside potential at this point for homebuilder stocks.

This article What Are the Declining Homebuilder Stocks Trying to Tell Us? was originally published at Investment Contrarians