Disappointing earnings roils Big Tech … record-high home prices … is our homebuilders trade still attractive? … the structural imbalance in the housing market As I write Wednesday morning, the market is selling off sharply due to earnings from Tesla and Alphabet that disappointed Wall Street. Adding to the selling pressure was the latest PMI flash manufacturing output index that fell to 49.5 in July. This was lower than expected, showing a contraction in new orders, production, and inventories. Suddenly, fear is back in the market. We'll look at this in more detail later this week, but today, as Wall Street continues a massive internal rotation out of tech stocks and into smaller stocks, let's put one such rotation trade on your radar. Long-time Digest readers are already in this trade and up 96%. But from the looks of it, there are plenty more gains on the way. So, today, as Big Tech pulls back, let's make the case for homebuilding stocks.
Yesterday, we learned that U.S. home prices hit a record high in June This comes after a record high in May. We continue to have a frozen housing market, paralyzed by the combination of these record-high prices and mortgage rates at nearly 7%. Here's The Wall Street Journal: The spring home-buying season, usually the busiest time of year for the housing market, was a dud this year. Home sales declined in June for the fourth straight time on a monthly basis. The combination of high prices and elevated mortgage rates has made homeownership less attractive to renters and deterred current homeowners from moving. The housing market continues to face the same challenge that's weighed on sales for years now… With today's record prices and nosebleed mortgage rates, most would-be homebuyers can't afford a home. Meanwhile, most homeowners aren't interested in selling because they don't want to become prospective homebuyers. This has resulted in the "lock-in" effect, which has translated into the worst home-buying affordability level since 1984, according to the National Association of Realtors. Now, while would-be homebuyers aren't enjoying this, it's been a tailwind for our homebuilders' trade. | ADVERTISEMENT  Investing experts Louis Navellier, Luke Lango, and Eric Fry are holding an emergency AI discussion.
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(By clicking the link, your email address will automatically be added to the Event RSVP list.) | Our trade on ITB keeps cruising along In our April 20, 2022, Digest, we suggested that aggressive investors could jump into an iShares Home Construction ETF (ITB) trade. ITB holds homebuilding heavyweights including DR Horton, Lennar, NVR, Pulte, and Toll Brothers. Our trade suggestion was due to the potential for major, multi-year gains we saw coming after the market bottomed from basement prices. Here was our disclaimer from that Digest about our timing and the potential for further volatility: If you're an aggressive trader who doesn't mind the possibility of being early and sitting through some sideways (or even down) action, this is a reasonable entry point. Reviewing this trade now, it was indeed a reasonable entry point. Below, you can see ITB falling further after our April Digest as we warned, but then rallying hard. An aggressive trader who took this ITB position would be up 96% right now, crushing the S&P which is down 23% over the same period. 
If you’re considering ITB today, keep an eye on its Relative Strength Index (RSI) level The RSI is a momentum indicator that measures the extent to which an asset is overbought or oversold. A reading over 70 suggests an asset is "overbought" (which increases the odds of a mean-reversion pull-back) while a reading below 30 means it's "oversold" (which increases the odds of a mean-reversion rally). Traders often reference a stock's RSI to help time entries and exits. As you can see below, ITB's RSI has been trading in and out of overbought conditions for the last two weeks. As I write Wednesday morning, the tech-induced broad-market selloff is dragging ITB lower, which has pulled its RSI down to 66.  Now, you might be wondering about ITB's vertical price spike on the right edge of the chart above. This surge happened after the cool June CPI data earlier this month. Traders saw the numbers and concluded, "the Fed will finally cut interest rates… that will bring down mortgage rates… that will loosen today's frozen housing market… let's get into homebuilding stocks."
With the market recently piling into this trade, and after being in it for more than two years, do we remain excited about its prospects looking forward? In short, yes. There will be volatility, but the same structural issues that have made our ITB trade a success so far remain intact. Primarily, we still face a severe shortage of housing supply. Here's NPR: There's a massive shortage of homes — somewhere between 4 and 7 million. And those who are able to find homes are spending a much bigger chunk of their paycheck than in recent years. And even though home construction has blossomed in recent years, a massive housing deficit remains. Here's Zillow from last month: Despite a pandemic construction boom, the U.S housing shortage grew to 4.5 million homes in 2022, up from 4.3 million the year before, according to a new analysis from Zillow®. This deepening housing deficit is the root cause of the housing affordability crisis… Across the country in 2022, there were roughly 8.09 million "missing households" — individuals or families living with nonrelatives. Compare that to 3.55 million housing units that were available for rent or for sale, and there is a housing shortage of more than 4.5 million. The pandemic-era housing frenzy sparked a construction boom, but thus far, that boom has fallen short. In 2022, 1.4 million homes were built — at the time, the best year for home construction since the early stages of the Great Recession. However, the number of U.S. families increased by 1.8 million that year, meaning the country did not even build enough to make a place for the new families, let alone begin chipping away at the deficit that has hampered housing affordability for more than a decade. Clearly, this is an imbalance that's favorable to homebuilders as we look ahead.
But in the shorter-term, could interest rate cuts from the Fed unlock the flood gates of existing home sales, putting pressure on builders? As I write, the CME Group's FedWatch Tool puts a 96.1% probability that the Fed will cut interest rates by at least one quarter-point in September. If the Fed follows through as expected, what would that mean for mortgage rates, housing affordability, and a thawing of today's frozen market? Well, one quarter-point cut isn't going to unleash the floodgates for either buyers or sellers. After all, the bond market (from which mortgage rates take their cue) is currently pricing in this rate-cut expectation, so we've already seen the move lower in mortgage rates. To illustrate, below, we look at the 30-year fixed rate mortgage. As you can see, in May, the rate clocked in at around 7.2% to 7.5%. But as of last week, it had already cooled to about 6.7% to 6.8%.  Source: Mortgage Daily News Despite this drop, we're clearly not experiencing a deluge of new buyers. So, how low would rates need to drop to move the needle? Let's go to Fortune: Anything below 6%, [Compass' chief executive, Robert Reffkin] suggested, would bring buyers back to the market. Lawrence Yun, the National Association of Realtors' chief economist, also recently said 6% would be the "new normal." With the 30-year fixed-rate mortgage at 6.8% – which has priced in a quarter-point cut – it's unlikely we're going to see it drop to 6% or below until deep into next year at the earliest… barring a recession which forces the Fed to slash rates. So, on our current trajectory, there is no imminent threat of a glut of existing housing inventory flooding the market. For the foreseeable future, a supply/demand imbalance remains, which is good news for our homebuilders trade. | ADVERTISEMENT  According to expert investors Eric Fry, Luke Lango, and Louis Navellier you have 60 days to move your money before a major AI event rocks the stock market.
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(By clicking the link, your email address will automatically be added to the Event RSVP list.) | Even better, this tailwind could last several years Here's Business Insider: How long it could take to close the gap depends on what data and assumptions are looked at. It could take just a handful of years — but that may not be likely in reality as this also would require massively increasing the number of housing starts. "If only single-family homes are considered, the rate of housing starts would need to triple to keep up with demand and close the existing 7.2 million home gap in 4 to 5 years," the Realtor.com report stated. [Hannah Jones, senior economic research analyst for Realtor.com] said the ramp-up in production needed to achieve that in just those few years isn't really a "reasonable expectation" for builders. "It will require sustained new construction activity, and it's likely that it will continue to be an issue for the years to come because it's just not likely that new construction activity is going to pick up to that level," Jones said.
And let’s not forget valuation Regular Digest readers know that I have my concerns about the broad market due to the elevated readings of various valuation indicators today. History suggests that today's richly valued prices increase the likelihood of underwhelming returns over the coming years. This is yet another reason why homebuilder stocks are attractive. While the price-to-earnings (PE) ratio for the S&P is 29 today – quite expensive – the S&P Dow Jones U.S. Select Home Construction Index has a PE ratio of less than half that, just 12.5. And when we dig into some of the top holdings of ITB, the PE ratios look even more attractive – even after the 96% return we've enjoyed since getting into this trade. Look at these PE ratios: - D.R. Horton Inc. (DHI) – 11.88
- Lennar Corp. (LEN) – 11.78
- PulteGroup Inc. (PHM) – 10.07
- Toll Brothers Inc. (TOL) – 9.26
So, what’s the action step? It's simple – be careful on your entry timing (recall the RSI chart from earlier), but ITB remains a very attractive trade. While there are some risks when we look farther out on the horizon, those issues are most likely years down the road, and a topic for a different Digest. Between now and then, there's plenty of time for ITB to make you a nice chunk of change. There's no need to rush in here due to today's overbought technical conditions, but when levels normalize, give ITB a look.
Have a good evening, Jeff Remsburg | 
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