It’s a Lose-Lose for Home Improvement Stores

Home Depot and Lowe’s find themselves in an environment they can’t control. At least as an investor, you can control your fate.

Feb 11, 2014 at 11:44AM

Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) have rewarded their investors over the past three years with stock appreciation of 120% and 95%, respectively. However, the pace has slowed over the past year, with these two companies delivering stock appreciation of 15% and 22%, respectively. The past month hasn't been kind to them, with Home Depot and Lowe's suffering stock depreciation of 8% and 7%, respectively.

At The Motley Fool, we don't usually pay attention to recent stock performances, instead focusing on the underlying companies. However, there are exceptions, and this is one of them. That's because these stock moves might signal a trend that retail investors aren't watching.

Sure, you might read a great deal of positive information on Home Depot and Lowe's. Why not? They're both great companies. On the other hand, ignoring industry trends would be akin to tossing $100 bills in the toilet. One particular trend should concern any Home Depot or Lowe's investor.

Move in rates
At the time of this writing and according to USA Today, the average rate on a 30-year fixed mortgage is 4.3%. This is considerably higher than the 3.5% rate seen in late 2012 and early 2013, which was made possible by QE3, or Quantitative Easing, implemented by the Federal Reserve. Quantitative Easing refers to the purchase of $85 billion per month of mortgage-backed securities, which drove rates lower.

If you were paying close attention, then you might have noticed that rates jumped to 4.4% last summer. This primarily occurred because the Federal Reserve hinted at a wind-down of QE3.

Currently, industry experts Mike Fratantoni (chief economist at Mortgage Bankers Association) and Lawrence Yun (chief economist at National Association of Realtors) expect rates to climb to 5.3% by the end of this year. Zillow also calls for rates to reach 5% later this year. Zillow doesn't just offer home valuations. It also owns the Zillow Mortgage marketplace "where borrowers connect with lenders to find loans and get mortgage rates." Therefore, Zillow is heavily involved in the business and should be seen as a reliable source. 

These predictions are being made because "the economy is improving." That phrase is in parentheses because I'm not in that camp. I see the high-end consumer improving, but that's partially based on investment performance and it isn't sustainable. Everyone else seems to be suffering.

Without the working class improving, an economic recovery doesn't exist. Nevertheless, if rates continue to increase due to an improving economy, then this will lead to waning demand for homes. This, in turn, would lead to fewer people looking to improve their new home, or make it their own. Those on an adjusted mortgage would have less capital available to spend on home improvements. Basically, if rates increased, this would negatively impact Home Depot and Lowe's.

The other possibilities
If it's proven that the economy isn't improving, then this might lead to lower rates, but where is the wage growth going to come from? The Federal Reserve can pump money into the system, but in order to see a sustainable economic recovery there needs to be wage growth, not underemployment. If this situation plays out, then fewer people will be able to afford homes, which would once again negatively impact Home Depot and Lowe's.

Playing devil's advocate against my own argument, the one possibility that could lead to continued growth for Home Depot and Lowe's is if lending standards ease considerably. However, if this takes place, then we would find ourselves right back where we started -- which refers to the mid-2000s. That didn't end well.

The Foolish bottom line
Are Home Depot and Lowe's quality companies that are likely to deliver for investors over the long haul? Yes. However, I'm not interested in steering any readers toward several years of losses prior to seeing those gains. In my opinion, the current economic environment, as well as the economic environment we're likely to see over the next several years, doesn't favor home improvement stores. Either rates increase and demand falls, or rates come back down which indicates that the economy isn't as strong as originally anticipated. I have been bullish on Home Depot and Lowe's for a long time, but I would now move to the sidelines. Please do your own research prior to making any investment decisions. 

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Zillow. The Motley Fool owns shares of Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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