An Extended Run for Homebuilders

The sector has enjoyed an unusual period of strength, and S&P now thinks it can continue over the next year

By Sam Stovall

Homebuilding has taken up residence in the roster of industries with top Standard & Poor's . Investors in these shares have so far had a constructive year: Through July 5, S&P's Homebuilding Index rose 19.4%, vs. a 13.0% drop in the S&P 1,500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600). That advance comes on top of a solid 2001 for the homebuilders, as the index far outperformed the broader market.

In June, S&P analyst Michael Jaffe moved back to a cautiously positive stance on the homebuilding group, from an underweight position. (Market weightings reflect the recommended holding of a sector in an investor's portfolio relative to that sector's percentage weighting in the S&P 1,500.)

What prompted his decision? Jaffe believes his March, 2002, call for an upturn in mortgage rates was premature. He notes that S&P's current forecast still calls for the U.S. economy to start to recover over the coming year. But the rebound is likely to be very gradual, with mortgage rates remaining low enough to keep homebuyers in the market. And with rates helping home purchases remain quite appealing, Jaffe says, shares of builders should continue to outperform over the next year.


  Jaffe points to a number of positive signals. New single-family, site-built home sales have been at or near record levels since 1998. Mortgage rates have been up and down during that period, but even at their May, 2000, peak of about 8.8%, they remained relatively affordable. At around 6.4% as of late June, 2002, 30-year fixed mortgage rates stood only 20 basis points above the 6.2% cycle low in October, 2001.

Given S&P's belief that the economic rebound will be moderate, Jaffe expects rates to remain in check. Mortgage rates typically have the largest influence of any factor driving home sales, based on their effect on monthly payments and income needed to obtain a home loan.

Besides rates, notes Jaffe, factors such as employment and consumer confidence influence consumers' homebuying decisions. In that regard, consumer confidence grew much stronger in 2002's first quarter, and weakness in the labor market has probably neared the bottom. So with mortgage rates likely to remain reasonable and consumers feeling more confident about spending, new-home orders should be solid in the coming year.


  Homebuilders tend to have their strongest investment returns early in an economic cycle, but Jaffe says that the current cycle has been different than most. Homebuilding is usually one of the first sectors to weaken as the economy slows -- and one of the first to emerge as interest rates head down. But rates were already very low when the economy started its descent in 2001, and vital homebuying trends almost staved off the recession.

However, with mortgage rates likely to remain relatively low, and the homebuilding sector being one of the only U.S. industries to record solid profit gains in recent periods, Jaffe thinks the group should continue to outperform.

S&P's top picks in the homebuilding group include Clayton Homes (CMH ), Hovnanian (HOV ), KB Homes (KBH ), and Lennar (LEN ), each of which is ranked 5 STARS (buy).

S&P Relative Strength Rankings

These industries carry 12-month relative strength rankings of "5" as of July 5, 2002 -- meaning that they're in the top 10% of the 114 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior 12-month price performance.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Air Freight & Logistics/Industrials FedEx (FDX) 5 STARS
Catalog Retail/Consumer Discretionary Insight Enterprises (NSIT) Not Ranked
Consumer Electronics/Consumer Discretionary Harman International (HAR) Not Ranked
Footwear/Consumer Discretionary Reebok (RBK) 4 STARS
Gold/Materials Barrick Gold (ABX) 4 STARS
Homebuilding/Consumer Discretionary Lennar (LEN) 5 STARS
Housewares & Specialties/Consumer Discretionary Fortune Brands (FO) 5 STARS
Managed Health Care/Health Care UnitedHealth (UNH) 5 STARS
Metal & Glass Containers/Materials Pactiv (PTV) 5 STARS
Specialty Stores/Consumer Discretionary Barnes & Noble (BKS) 5 STARS
Trucking/Industrials Yellow Corp. (YELL) 5 STARS

*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief sector strategist for Standard & Poor's

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