Why Homebuilder Stocks are Suddenly Plunging

Homebuilder stocks had soared in 2012 in the early stages of the housing recovery, but have since leveled off and had perhaps peaked earlier this year.

Then Thursday, major homebuilder stocks plunged amid fears of rising mortgage rates.

The declines came a day after the Federal Reserve suggested it may reduce the bond buying that has pumped up equity markets for more than a year.

Experts noted that homebuilder stocks are particularly sensitive to rising interest rates.

With rising rates, said Money Morning Chief Investment Strategist Keith Fitz-Gerald, "The homebuilders are going to have to do one of two things: They're either going to have to stop building because there's no demand or they're going have to lower their prices, which is going to hurt their profit margin."

In the short term, Fitz-Gerald said, we could see a spurt in home buying as those with mortgage applications in progress rush to lock in interest rates before they rise, but that increase likely will subside within a few months.

Homebuilder Stocks: The Toll

In mid-afternoon trading yesterday, PulteGroup Inc. (NYSE: PHM) was down more than 11%, to $18.47; DR Horton Inc. (NYSE: DHI), about 9.5%, to $21.20; Lennar Corp. (NYSE: LEN), nearly 8.5%, to $34.62; KB Home (NYSE: KBH), more than 8%, to $19.44; Standard Pacific (NYSE: SPF), about 8%, to $8.23; and Toll Brothers Inc. (NYSE: TOL), about 6%, to $31.13.

Meantime, the exchange-traded fund for the homebuilding industry, SPDR Home Builder (NSYSE: XHB), was down nearly 5.5%, to $29.19.

The declines come after sharp gains earlier. Megan McGrath, an analyst at MKM Partners, noted major homebuilder stocks had climbed an average of 118% in 2012.

But, she told Money Morning, "What I would say is I think the vast majority of returns to be made on the housing recovery have already been made. ... There are a few names that still have upsides but I don't think you can rely on sort of the rising housing tide to lift all boats anymore.

"Investors need to be a bit more cautious and you know," McGrath said. "We think stock picking is now more important, especially now that there is concern in the market over the impact that rising mortgage rates could have on the trajectory of the housing recovery and that has started to negatively impact the shares. The stocks have been very sensitive to mortgage rates in the past and we expect that to continue."

But McGrath said MKM believes KB Home and Toll Brothers will outperform other homebuilder stocks and the firm has rated both a "buy."

The luxury homebuilder Toll Brothers isn't as sensitive to mortgage rate changes and KBH is succeeding by targeting coastal California markets and wealthier first-time buyers, enabling it to increase average selling prices and therefore margins.

The day before homebuilder stocks plummeted, the National Association of Home Builders issued an upbeat news release on housing starts, which rose 6.8% in May mainly because of increased construction of multifamily homes.

Differing Views of the Market

"The outlook for housing continues to brighten as builders respond to increased demand for new homes and rental apartments," NAHB Chairman Rick Judson, a homebuilder from Charlotte, NC, said in the release. "While challenges with regard to the cost and availability of building materials, lots and labor are still keeping the pace of improvement in check, both builders and consumers are more confident about their prospects in the current marketplace."

Sales of new single-family houses in April 2013 hit a seasonally adjusted annual rate of 454,000, the second-highest level since 2008, and 29% above the April 2012 estimate of 352,000.

And earlier this week, the new survey of homebuilder confidence from Wells Fargo Bank and the National Association of Home Builders climbed to its highest level since 2006.

But Money Morning's Fitz-Gerald said homebuilders are putting the best possible spin on bad news - rising interest rates that will hurt sales.

"The homebuilders are going to try to game this. They're going to say, 'Hey, we're fine, we're well-positioned, we've got capital reserves, we've got this, we've got that,'" Fitz-Gerald said.  "The reality of the situation, however, is that if they're not selling homes, they're not making money."

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