As an investor, you should always be asking where we are in the economic cycle. The sectors that generally perform well in a recession (consumer non-discretionary) will generally underperform as the economy begins its expansion. The classic go-to sector when the economy begins its turnaround has been the homebuilders and the financials. This is because these sectors are interest rate-sensitive and the Fed typically reduces the prime lending rate during a recession. Low borrowing rates are an elixir for banks and builders.

Right now, investors looking for clues should be watching the housing market, especially the homebuilders, as a tell on where we are in the economic cycle. Toll Brothers (NYSE:TOL) recently reported earnings and provided some interesting anecdotal evidence on the state of the housing market. 

Architect drawing of house

Image source: Getty Images.

One of the more interesting things about the homebuilders is that many have odd fiscal years. While banks generally have end-of-December fiscal years, the builders are more mixed. Most still maintain a December fiscal year, but Toll Brothers uses the end of October quarter to finish out its fiscal year. The company recently reported earnings for its second quarter, which ended on April 30. This gives us an extra month's worth of insight on the housing market currently being influenced by COVID-19. 

A tale of two halves

As expected, Toll Brothers reported depressed earnings compared to a year ago, with earnings per share falling to $0.59 per share from $0.87 per share a year ago. Home sales revenue fell 11% to $1.52 billion from $1.71 billion a year ago. The quarter was more or less bifurcated into pre-COVID and post-COVID. The quarter started off strong before the economy hit a wall in mid-March. Orders were up 43% in the first half of the quarter before collapsing. That said, the company noted that one leading indicator had begun to tick up -- deposit activity. Toll Brothers CEO Douglas Yearley had this to say regarding the turnaround: 

While net signed contracts in the first four weeks of May were down 37% year-over-year, we are very encouraged by recent deposit activity. Our deposits, which typically precede a binding sales contract by about three weeks and represent a leading indicator of current market demand, were up 13% over the past three weeks versus the same three-week period last year. Importantly, our recent deposit-to-contract conversion ratio has remained consistent with pre-Covid-19 levels. Web traffic has also steadily improved from the lows we experienced in mid-March and has returned to the same strong activity we enjoyed pre-Covid-19 in February. These early trends suggest the housing market may be more resilient than anticipated just two months ago. 

Pricing is holding up

On the conference call, the company said that in the fourth week of May, deposits were the highest since 2005. Here is how they generally work. The customer will post a deposit, which reserves a site and begins the customization process. After about three weeks, the deposit hopefully turns into an order. Toll has not seen any sort of decline in the deposit-to-order conversion rate, which is a good sign. The increase in deposits was not due to any sort of discounting either. Pricing has been strong. On the conference call, Yearley had this to say about pricing:

I'm actually pleased that in a couple of locations, let's call it 10 to 20 around the country, we've had some modest price increases over the last three to four weeks. A few have been new grand openings that have been very successful, and others have been established communities that have a very strong demand. But in terms of running any special to drive the last three weeks of strong activity, absolutely not. And I'm not inclined to incentivize right now at all. I don't think we need to, and I don't think this is the time to do that.

Toll Brothers' liquidity is in good shape as well, with $741 million of cash and $1.3 billion in capacity on its revolving credit agreements. The company has no significant debt maturities until next year. Toll Brothers' stock is trading at 10.6 times estimated 2020 earnings per share and is down about 21% year-to-date.

While it may be early to rotate out of defensive stocks and into the early stage cyclicals, it is time for investors to start putting together a shopping list of stocks for that stage of the recovery. While Toll Brothers is a solid homebuilder, entry-level starter homes seem to be the place to be, and that sector of the housing market should rebound first. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.