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Having survived a rough patch in the 2007–2009 time frame, the housing market continued on an uptrend all through 2012, buoyed by significant upside in new home sales volume and improvement in other key macroeconomic indicators.
 
However, interest rates which were at historically low levels and helped the homebuilding sector in becoming a star performer, have started to move upwards since May 2013, thus making homes comparatively pricier.
 
Interest rates have risen sharply since May thanks mainly to the  tapering concerns. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has risen from 3.59% on May 23 to 4.58% on August 22 (read Protect Against Rising Rates with Floating Rate ETFs).
 
While it is not yet known whether the central bank will begin to slow down the bond buying program from next month or even this year, the market has already prepared for the ineveitable move. The potential scaling down of this massive QE program has led to the slump in most of the homebuilders’ stocks.
 
Why Rising Rates are a Concern?
 
High interest rates make mortgage loans expensive which in turn weakens the demand for new homes. This clearly explains why new-home sales numbers are indicative of the housing recovery. In fact, new home sales in July were reported (on August 23) to have dropped a sharp 13.4% sequentially thereby posing a threat to hopes of a continued housing recovery (Read: 3 Sector ETFs to Profit from Rising Rates).
 
Quite expectedly, the data punished the broader markets and the homebuilding ETFs. The three funds tracking the sector –iShares Dow Jones US Home Construction ETF (ITB - ETF report), SPDR S&P Homebuilders ETF (XHB - ETF report) and PowerShares Dynamic Building & Construct (PKB - ETF report) – lost a respective 3.10%, 1.58% and 1.90% within five days of this bearish news. The July figure was also much below the median estimate of economists surveyed by Bloomberg.
 
The better-than-expected earnings at most homebuilders this season could not hold back the downward drift in stock prices (Read: What is Knocking Homebuilders Down?).
 
Is There Any Hope?
 
The outlook for the sector still looks positive considering the fact that new home sales are still up 6.8% from the year-ago period. Further, in stark contrast to weak new home sales data, sales of existing homes rose 6.5% sequentially and 17% year over year in July touching a four-year high level.
 
Moreover, housing starts across the U.S. also witnessed a sequential increase of 5.9% and year-over-year gain of 20.9% in July mainly on account of multifamily homes.
 
If these assuring data were not enough, we believe, there is still considerable amount of pent-up demand in the homebuilding sector to pull it off in the coming days. Further, it has become more than three months now since taper talk started and investors are getting used to the issue. We believe by now the market has priced in most of the concerns. Further, even with the recent spike, interest rates are still lower than the average rate of 6.14% during 1971 to 2013.

Market Impact

Despite worries about rate increases, the recent dip can be considered an entry point to the U.S. homebuilding sector. Below, we briefly highlight the three funds in the space which could be great picks with decent Zacks Rank and a moderate level of risk.

While XHB and ITB amassed around $2 billion in assets so far, PKB is a bit overlooked with around $101.2 million AUM. Among the three, XHB is the cheapest charging around 35 basis points in annual fees while ITB and PKB charge 48 bps and 60 bps respectively.

Over the last one year period ending August 27, XHB, ITB and PKB returned around 23.46%, 31.32% and 16.29%, all of which are quite attractive compared with the level returned by the S&P 500 index.

Investor should note that all three funds have major investment in mid-cap and growth stocks, thus being a bit volatile than the traditional large-caps and value funds. Further, among the three, only ITB is a pure-play on the homebuilding sector allocating around 60% of its assets to this space, and then another 10% (roughly) to building materials.

XHB has just one-quarter of its portfolio in homebuilders while PKB is a more diversified choice with only 6% allocation in home-builders. This clearly explains why ITB suffered more (down 14%) than its other counterparts XHB (down 4%) and PKB (flat) since May on rising rate cues.



Bottom Line
 
Even though the current scenario is not quite inspiring, it is also not time to panic. Several other indicators like rising house prices, tight inventory, improving homebuilder sentiment index and job data should also not be ignored. Most homebuilders believe the housing momentum will continue into 2014. Considering these, the homebuilder ETF outlook — at least over the long term — isn’t as grim as one might think. Presently, ITB boasts a Zacks Rank #1 (strong Buy) and XHB carries a Zacks Rank #2 (Buy) (see more ETFs in the Zacks ETF Center).
 
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