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Wall Street loves to buy the rumor and sell the news.
Why else do you think stocks are rallying to record highs this summer?
The ultimate rumor today is the "Federal Reserve Put."
Dovish policy from the central bank means traders are willing to take more risk. Stocks have been going up ever since the change in tone back in January.
The expectation is for the central bank to now cut interest rates.
It's not exactly a secret.
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Usually in these situations, the market will sell off when the news actually becomes reality.
Why Is the Federal Reserve Cutting Rates?
There is a very good reason the Federal Reserve will be cutting rates soon.
Inflation is nonexistent.
That means interest rates on the long end of the curve are falling hard.
A little short-term rate cut is not going to change that, and the bond market knows it.
As such, those long-term rates are going down, down, and down some more.
Only quantitative easing and flooding cash into the system will change the inflation story. But we are still far away from that happening.
So while we watch long-term bond rates, the homebuilding sector is going to take off.
Entirely dependent on low mortgage rates to spur buying demand, homebuilders do not do well when inflation is present.
Homebuilders will also struggle when there is a recession, but there is minimal of chance of negative economic growth anytime soon.
So while the stock market may react negatively to the actual rate cut, homebuilding stocks are going to increase in value as mortgage rates fall.
It is somewhat of a perfect storm for the sector.
On a fundamental basis, the timing to buy homebuilding stocks is fantastic.
A great rule of thumb is to use book value as your guide on homebuilder stock valuation.
When homebuilder stocks trade for book value or less, it has been a great time to buy historically.
The opposite is true when homebuilder stocks trade for much greater than book value.
The inefficiency in the market today is that several homebuilder stocks are trading for book value or less.
That's because investors are convinced a recession or worse is on the horizon.
The data just doesn't support such an outcome.
Therefore, homebuilder stocks should be bought when the Federal Reserve cuts rates even if the rest of the market is selling the rumor.
Here are two of my favorites...
Homebuilding Stocks to Buy Now, No. 2
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Aside from the obvious valuation and timing reasons to own homebuilder stocks, the macro conditions of minimal supply bodes well for future profits.
If a homebuilding stock trades for book value, the market is assuming that profits in the near term will be hard to come by.
In the case of KB Home (NYSE: KBH) the company is positioned to exploit excess demand for entry-level home buyers.
At 1.06 times book value at the moment, KB Home is priced for a recession.
What will more than likely unfold is a boom in buying.
Sure, in the long term, all that buying will result in asset price appreciation that will be difficult to maintain. But in the near term, profits are all but baked in for KB Home.
KB Home is expected to make $2.70 per share this year, with that number growing 11% to $3 per share in 2020.
That's far from negative territory.
When the central banks cut rates and mortgage rates fall, KB Home will likely increase in value.
In my mind, 1.5 times book value is more reasonable given the actual performance of the company and current conditions.
Homebuilding Stocks to Buy Now, No. 1
Stepping up in class is luxury homebuilder Toll Brothers Inc. (NYSE: TOL).
Eventually, this economy is going to run hot, and when it does, Toll Brothers is poised to benefit greatly.
The jobs market is rock solid, and consumer balance sheets are getting stronger.
Lower mortgage rates on the heels of a Federal Reserve rate cut will spur demand.
There is minimal risk of profits for Toll to suddenly turn negative.
So why does the stock trade for 1.09 times book value?
It really makes no sense, but who cares when rational investors like us can exploit the opportunity?
Analysts expect Toll Brothers to make $3.87 per share in the current year, with that number growing by 9% in 2020.
The Federal Reserve rate cut is a catalyst to buy shares at these levels.
With mortgage rates falling, profits will likely be higher, not lower.
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