The long-awaited rate cut looks set to happen this week, but homebuilder stocks have been rallying in anticipation of that moment since October 2023, when the Fed signaled that hikes were over. That leaves the group with little room for error, according to RBC Capital Markets. Analyst Mike Dahl sees the stocks as “priced for perfection” as industry fundamentals remain volatile beneath the surface. He said stocks in the firm’s coverage universe have “substantially over-delivered on the benefits of anticipated rate cuts, far outpacing previous Fed cycles.” Despite that, Dahl expects Toll Brothers, Taylor Morrison Home and Tri Pointe Homes to outperform the group. Toll Brothers is up 46% in 2024, while Taylor Morrison is up more than 28% and Tri Point is up 25%. The S&P Homebuilders ETF (XHB), which tracks the S&P 500 index of homebuilders, is up about 26% in 2024, with a 15% gain over the past three months as signs of a meaningful slowdown in inflation grow and investors become more optimistic that interest rates will start to come down. The XHB 1Y mountain Spdr S&P Homebuilders ETF over the past year. According to RBC, the average of the past five Fed cycles has seen stocks gain over 12 months of just 4% for homebuilder stocks it covers, and 15% for building products companies. Even in the mid-1990s, when the Fed orchestrated a “soft landing,” homebuilder stocks saw an average gain of 19%, according to RBC. “It’s not clear to us that initial rate cuts will do much to make a meaningful difference here (and a deeper/faster rate cut cycle would likely indicate a more worrisome fundamental backdrop),” Dahl said. The market is heading into Tuesday’s Federal Reserve policy meeting very confident of a rate cut, but the magnitude is a big topic of debate. Traders are pricing in a 59% chance of a 50 basis point cut from the central bank, according to the CME Group’s FedWatch tool. The odds of a smaller 25 basis point cut have dropped to a 41% chance. ‘Caution is warranted’ While the market is looking for a more aggressive move, many economists have been advocating moderation. One concern that could accompany a deeper cut is that it could signal that Fed officials fear the economy is weakening quickly. “The gradual deterioration in consumer/employment remains the key risk, as equities have been a two-way performer in previous rate cuts, and depends on whether the cuts succeed in staving off a recession,” Dahl said. “We think caution is tactically warranted across our portfolio, though more so for developers where valuations are overvalued, in our view,” he said, citing Lennar and KB Home as examples where valuations could be overvalued. Lennar shares are up more than 24% in 2024, and Dahl thinks they are relatively overpriced to return on tangible equity. KB Home shares are up 38% year to date, but most analysts rate the stock a hold or sell. Analysts expect KB Home shares to fall more than 10% based on their average price target, according to FactSet. “We believe the theoretical improvement in housing fundamentals ahead as prices continue to moderate is largely reflected in valuations at this point, while continued price volatility amid mixed economic, inflation and employment prints will likely create a volatile trading environment until there is more clarity on a true soft landing versus recession,” he said. Barclays analyst Matthew Pauly is also watching the data closely and said much will depend on how consumers react to lower mortgage rates. “At current valuations, we believe homebuilder stocks are fully predicated on lower mortgage rates driving continued improvement in housing fundamentals through 2025, without a concurrent rise in unemployment,” he wrote Tuesday. Housing data tepid Pauly noted that inventories of both existing and new single-family homes are rising, single-family housing starts are weak, and weekly mortgage applications have shown only a slow improvement. But he was encouraged that new home sales data for July showed an improvement, up 11% month-over-month and up 6% year-over-year. Pauly said it’s one of the clearest signs yet that the recent decline in mortgage rates is bringing buyers into the market. Last week, mortgage rates hit their lowest level since February 2023, meaning rates are about a full percentage point lower than the same week last year, for a conventional 30-year fixed-rate loan. “Tactically, the improved housing data should support stocks, but the risk/reward is more balanced,” Pauly said. The dynamic will end up favoring larger builders, a group that includes giants like DR Horton. “They are relatively more resilient compared to smaller/private builders, as the ability to implement incentives and take advantage of a greater geographic and demographic mix of buyers should enhance demand and margin resilience against macro trends,” he said. Such incentives are important in a climate where housing affordability remains a major issue. DR Horton shares are trading near their average price target, according to FactSet. More than half of analysts covering the stock rate it a buy or overweight, it said.
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Homebuilder stocks are “perfectly priced,” and investors need to see lower interest rates drive demand.
