A long-awaited interest rate cut seems all but certain to happen this week, but homebuilder stocks have been climbing in anticipation of this moment since October 2023, when the Federal Reserve signaled the hikes had come to an end. That leaves the group with little room for error, according to RBC Capital Markets. Analyst Mike Dahl sees the stocks “priced for perfection” as industry fundamentals remain choppy underneath the surface. Stocks in the firm’s coverage universe have “significantly front-loaded expected rate cut benefits, well in excess of prior fed cycles,” he said. Despite that, Dahl expects Toll Brothers , Taylor Morrison Home and Tri Pointe Homes to outperform the cohort. Toll Brothers stock has advanced 46% in 2024, while Taylor Morrison has climbed more than 28% and Tri Point has risen 25%. The S & P Homebuilders ETF (XHB) , which tracks the S & P 500’s homebuilders index, has advanced nearly 26% in 2024, with a 15% surge over the past three months as signs of slowing inflation grew more tangible, and investors became more hopeful rates would start to come down. 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 stock gains of just 4% for the homebuilder stocks the firm covers, and 15% for the building products companies. Even in the mid-1990s when the Fed orchestrated a “soft landing,” homebuilder stocks saw an average 19% gain, RBC said. “It’s unclear to us that initial rate cuts will do much to spark a meaningful change here (and a deeper/faster cutting cycle would likely indicate a more worrisome fundamental backdrop),” Dahl said. The market is heading into Fed’s policy meeting on Tuesday very confident that an interest rate cut will be made, but the magnitude is a topic of great debate . Traders are pricing in a 59% chance of a 50 basis point cut from the central bank, according to the CME Group’s FedWatch tool . The chances of a smaller 25 basis point cut have fallen to a 41% chance. ‘Caution is warranted’ While the market is looking for a more aggressive move, many economists have been advocating for moderation. One worry that could accompany a deeper cut is that it would suggest Fed officials are fearing the economy is weakening quickly. “Incremental consumer/employment deterioration remains the key risk, as stock performance has been binary in prior cutting cycles, hinging on whether cuts succeed in staving off recession,” Dahl said. “We believe caution is warranted tactically across our group, though most meaningfully for builders where valuations are more overextended, in our view,” he said, citing Lennar and KB Home as two such examples where valuations may be pricey. Lennar shares have advanced more than 24% in 2024, and Dahl thinks it is price high relative to a return on tangible equity basis. KB Home shares are up 38% year to date, but most analysts rate the stock a hold or sell. According to FactSet, analysts expect KB Home shares could pull back more than 10% based on the average price target. “We believe the theoretical improvement in housing fundamentals to come as rates continue to moderate is largely reflected in valuations at this point, while ongoing rate volatility amid mixed economic, inflation, and employment prints likely create a choppy trading environment until visibility becomes clearer on a true soft landing vs. recession,” he said. Barclays analyst Matthew Bouley is watching the data very closely as well and said a lot will depend on how consumers react as mortgage rates fall. “At current valuations, we think homebuilder stocks are fully dependent on lower mortgage rates driving continued improvement in housing fundamentals into 2025, without a concurrent rise in unemployment,” he wrote on Tuesday. Lukewarm housing data Bouley noted inventories of both existing and new single family homes are rising, single family housing starts are soft, and weekly mortgage applications have only made sluggish improvements. But he was encouraged that new home sales data in July showed improvement, notching an 11% increase month-over-month and a 6% gain year-over-year. Bouley said this is one of the clearest signs yet that a recent decline in mortgage rates is bringing buyers into the market. Last week, mortgage rates hit their lowest level since February 2023, which means rates are nearly a full percentage point lower than the same week a year ago, for a conventional 30-year fixed rate loan. “Tactically, improving housing data should support the stocks, but the risk/reward has become more balanced,” Bouley said. The dynamic will end up favoring larger builders, a group that includes behemoths like D.R. Horton . He said they are “more resilient relative to smaller/private builders, as the ability to apply incentives and capitalize on greater geographic and buyer demographic mix should reinforce demand and margin resiliency vs. macro trends.” Such incentives are important in a climate where housing affordability remains a key issue. D.R. Horton shares are trading near their average price target, according to FactSet. Slightly more than half the analysts who cover the stock rate it a buy or overweight, it said.
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