A long-awaited rate cut looks almost certain to happen this week, but shares of homebuilders have been rising ahead of that moment since October 2023, when the Federal Reserve signaled that hikes are coming to an end. That leaves the group with little room for error, according to RBC Capital Markets. Analyst Mike Dahl sees the stock as “priced for perfection” as industry fundamentals remain shaky beneath the surface. Stocks in the firm’s coverage universe have “significant upfront expected rate cut benefits, much more than previous feeding cycles,” he said. Still, Dahl expects Toll Brothers, Taylor Morrison Home and Tri Pointe Homes to outperform the cohort. Toll Brothers stock is up 46% in 2024, while Taylor Morrison is up more than 28% and Tri Point is up 25%. The S&P Homebuilders ETF (XHB), which tracks the homebuilders index of the S&P 500, is up nearly 26% in 2024, up 15% over the past three months as signs of slowing inflation became more tangible and investors became more hopeful interest rates would begin to fall. XHB 1Y mountain Spdr S & P Homebuilders ETF over the past year. According to RBC, the average of the past five Fed cycles saw 12-month gains of just 4% for the homebuilding stocks the firm covers and 15% for building products companies. Even in the mid-1990s, when the Fed orchestrated a “soft landing,” homebuilder stocks rose an average of 19 percent, RBC said. “It’s not clear to us that the initial rate cuts will do much to spark a meaningful change here (and a deeper/faster cut cycle would likely indicate a more worrisome fundamental backdrop),” Dahl said. The market heads into the Fed’s policy meeting on Tuesday with high confidence that a rate cut will take place, but the size is a matter of much debate. Traders are pricing in a 59% chance of a 50 basis point cut by the central bank, according to CME Group’s FedWatch tool. The odds of a smaller cut of 25 basis points have fallen to 41%. ‘Caution called for’ While the market looks for a more aggressive move, many economists advocate moderation. One concern that could accompany a deeper cut is that it would suggest Fed officials fear the economy is weakening fast. “A gradual deterioration in consumer/employment remains the key risk, as equity performance has been binary in previous cut cycles on whether cuts succeed in averting a recession,” Dahl said. “We believe that tactical attention is required across our group, although most importantly for manufacturers where valuations are more stretched, in our view,” he said, citing Lennar and KB Home as two such examples where valuations may be it is accurate. Lennar shares are up more than 24% in 2024, and Dahl believes the price is high relative to the return on physical shares. Shares of KB Home are up 38% year to date, but most analysts rate the stock a hold or sell. According to FactSet, analysts expect shares of KB Home could fall more than 10% based on their average price target. “We believe the theoretical improvement in housing fundamentals to come as interest rates continue to moderate is largely reflected in valuations at this point, while continued volatility in interest rates amid mixed economic, inflation and employment conditions likely creates a volatile trading environment until visibility becomes clearer. true soft landing against recession,” he said. Barclays analyst Matthew Bouley is also watching the data very closely and said much will depend on how consumers react as mortgage rates fall. “At current valuations, we believe homebuilder stocks are fully dependent on lower mortgage rates leading to continued improvement in housing fundamentals through 2025 without a concomitant rise in unemployment,” he wrote on Tuesday. Lukewarm Housing Data Bouley noted that inventories of both existing and new single-family homes are rising, starts for single-family homes are soft and weekly mortgage applications have made only modest improvements. However, he was encouraged that new home sales figures for July showed an improvement, up 11% month-on-month and a 6% year-on-year gain. Bouley said this is one of the clearest signs yet that a recent drop in mortgage rates is bringing buyers into the market. Last week, mortgage rates hit their lowest level since February 2023, meaning rates are almost a full percentage point lower than the same week a year ago for a 30-year fixed-rate conventional loan . “Regularly, improving housing data should support stocks, but the risk/reward has become more balanced,” Bouley said. The momentum will end up favoring the biggest manufacturers, a group that includes behemoths like DR Horton. He said they are “more resilient than smaller/private manufacturers, as the ability to implement incentives and tap into a wider geographic and demographic mix of buyers should boost demand and margin resilience against macroeconomic trends.” Such incentives are important in a climate where housing affordability remains a key issue. Shares of DR Horton are trading near their average target price, according to FactSet. Slightly more than half of analysts covering the stock rate it a buy or overweight, it said.
