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3 Reasons Why Homebuilders Are Set to Rally Further

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As we close out the first quarter of 2023, most investors would’ve balked at the idea that homebuilders are up 30% off the bear market bottoms. For the majority of last year, this group severely underperformed the market. Yet here we are, with homebuilders continuing to rally in the New Year in the face of elevated mortgage rates and declining home prices.

The Zacks Building Products – Homebuilder industry has returned more than 16% year-to-date, handily outpacing the market. This industry is currently ranked in the top 20% out of approximately 250 industries. Because it is ranked in the top half of all Zacks Ranked Industries, we expect this group to outperform over the next 3 to 6 months. Take a look at how this group has steadily outperformed this year:

Zacks Investment Research
Image Source: Zacks Investment Research

Quantitative research studies suggest about half of a stock’s future price appreciation is due to its industry grouping. In fact, the top 50% of Zacks Ranked Industries outperforms the bottom 50% by a factor of more than 2 to 1. By targeting stocks contained within leading industry groups, we can dramatically improve our odds of success.

Why are homebuilder stocks not only rallying, but vastly outperforming the market? Let’s review three potential reasons why this is the case.

The Outlook for Mortgage Rates

Mortgage rates surged last year, topping out just over 7%, but 30-year fixed rates have now begun to decline:

Image Source: StockCharts

And while mortgage rates are not directly tied to the Fed’s decision-making regarding the range of the federal funds rate, more certainty around Fed actions (including a potential pause in May) will help stabilize some of the volatility we’ve seen in mortgage rates in recent months.

Incoming economic data will also serve a role in the decline in rates. Tomorrow’s release of the Personal Consumption Expenditures (PCE) index is expected to show a continued deceleration in price increases. Declining inflation data should help mortgage rates soften further. Lower rates will help spur additional buying and propel homebuilder stocks.

Homebuilder Valuations

We all know that the market is forward-looking. Perhaps a widely-anticipated housing downturn simply won’t come to fruition as supply remains low, and rate hikes are closer to an end than a beginning. But a deeper look reveals another possibility: valuation.

Homebuilder stocks shed nearly 40% of their value from peak to trough during last year’s bear market, and many individual companies are still relatively undervalued. This could be a correction to the upside, with these stocks simply returning to more normal levels after last year’s extreme drop.

Continuing with our example from earlier, an analysis of the Zacks Building Products – Homebuilder industry shows that this group remains relatively undervalued:

Zacks Investment Research
Image Source: Zacks Investment Research

Lower Costs to Build

Last year saw a surge in prices as well as supply chain disruptions that made it very difficult for homebuilders to complete projects on time. But prices have now come down, and supply chain issues have eased significantly. Lumber, which was trading at $1,329 per thousand board feet back in January of 2022, has now dropped to approximately $375. This represents a greater than 70% drop in a key component for builders.

The Global Supply Chain Pressure index integrates transportation cost data as well as manufacturing indicators to provide a gauge of supply chain conditions. The index’s recent movements suggest that global supply chain conditions have returned normal after experiencing substantial setbacks last year:

Bureau of Labor Statistics, New York Fed
Image Source: Bureau of Labor Statistics, New York Fed

Individual Homebuilder Stock Pick

One well-known homebuilder that has led the charge during the recent rally is Toll Brothers (TOL - Free Report) . Toll Brothers is based in Fort Washington, PA and builds single-family detached and attached home communities. TOL operates its own engineering, architectural, mortgage, title, home security, and landscape subsidiaries. The company is also known for its urban low, mid and high-rise communities on land it develops and improves.

TOL is currently a Zacks Rank #2 (Buy) stock and is ranked favorably by our Zacks Value Style Score category, with a best-in-class ‘A’ rating that indicates promising valuation metrics. The stock trades relatively undervalued at just a 6.86 forward P/E.

Toll Brothers has exceeded earnings estimates in each of the past four quarters, with an average surprise of 18.33%. The community home developer most recently reported fiscal Q1 earnings last month of $1.70/share, a 24.1% surprise over the $1.37 consensus estimate. Sales of $1.78 billion also surpassed estimates by 2.16%.

Zacks Investment Research
Image Source: Zacks Investment Research

For the current quarter, analysts have increased earnings estimates by 7.39% in the past 60 days. The fiscal Q2 Zacks Consensus Estimate now stands at $1.89/share, reflecting potential growth of 2.16% relative to the same quarter last year.

Zacks Investment Research
Image Source: Zacks Investment Research

This rally in homebuilders appears to be the real deal. There’s still plenty of pessimism surrounding this group, something that can likely fuel more upside. One thing’s for sure – homebuilders are an important group to watch as we near the second quarter of the year.

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