The U.S. economy continues to improve at a gradual pace, which is leading to strong momentum in the housing market. The accommodating monetary policy by the Federal Reserve was a serious tailwind for housing during the early part of 2013, and the major home builders benefited handsomely from an environment of low interest rates and attractive home prices.
As housing momentum gains steam, however, rising rates threaten the fragile housing recovery. Home builder stocks seem cheap on the surface, but if progress in the housing market is about to come to a screeching halt, these stocks may turn out to be value traps.
Economic recovery remains intact
The economy in the United States continues its gradual, albeit slow, recovery from the financial crisis. The labor market is especially critical for the housing market, and progress on the job front has been noticeable over the past year. As a result, strength in the housing market continues, and is being reflected in recent data points.
Sales of new homes constructed in the United States jumped 7.9% in August, to an annualized rate of 421,000 homes, representing the biggest one-month gain since January. This was an important development for the housing market, which had showed signs of weakness in recent months with the onset of higher mortgage rates. New home sales plunged 14% in July, so August's improvement was especially important.
Therefore, it seems as though Americans are returning to the labor force, firming their financial positions, and buying homes. This has been evident in the earnings reports released so far in 2013 from the home building industry leaders, including PulteGroup (NYSE:PHM), Lennar (NYSE:LEN), and Toll Brothers (NYSE:TOL).
Pulte grew revenue and gross profit by 25% and 19%, respectively, over the first half of its fiscal year. Lennar and Toll Brothers have reported earnings through the first three quarters of their fiscal years, and the results have been equally encouraging. Lennar is seeing strength across its key metrics. Revenue has soared 52% through the first nine months, driven by increases in both volume of home deliveries and prices. Home deliveries soared 36%, while average sales prices grew 12% versus the same period last year.
For Toll Brother's part, revenue and units delivered increased 30% and 23%, respectively, through the first three quarters of the year, and the company is expecting continued strength in the fourth quarter. Toll Brothers' chief financial officer, Martin Connor, stated recently that fourth-quarter deliveries are expected to fall between 1,225 and 1,425 units at an average sales price of between $675,000 and $695,000. Should the company realize these targets, both metrics would represent full-year growth versus fiscal 2012.
A stiff potential headwind
The current environment is favorable to home builders, but a future complication may soon strike in the form of rising interest rates, which would likely result in lower demand for mortgages. This is already reverberating through the housing market, and represents a key consideration going forward. The average rate on 30-year fixed mortgages has risen more than a full percentage point since May. And while the Federal Reserve made it abundantly clear that it would wait to raise short-term interest rates until economic data improved measurably, long-term rates are market driven, and may not wait for cues from the Federal Reserve.
The 10-Year U.S. Treasury Bond yield has reached 2.65%, and mortgage rates are following suit. This will likely cause the housing recovery to sputter, but at the same time, higher interest rates are often symptomatic of an improving economy. The historically low interest rates we've seen since the onset of the financial crisis were an attempt to rescue an economy on the brink of collapse. Rates can't stay that low forever, and that's not necessarily a bad thing.
As a result, the attractive valuations of many home builder stocks appear to be true values and not value traps. The improving fundamentals probably have legs; while I wouldn't expect the exact same superb growth in home builder underlying results to continue, the housing recovery should proceed for the foreseeable future. Even if interest rates keep going higher, it will be because we're finally in a healthy, self-sustaining economy. Consequently, these home builder stocks remain attractive in my view.
Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.