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U.S. home builder stocks fell almost two per cent Wednesday and the sector's long-term relationship with interest rates suggests investors in the sector have plenty of reason for worry.
Home-building stocks and two year U.S. Treasury yields have historically moved in the same direction, with a six month lag on average. The usual caveats about correlation and causation apply, but subjectively, at least, its clear why homebuilding stocks would be a leading indicator for interest rates. More homes are built when interest rates and mortgage rates are low, which both drives up profits for builders and increases inflation pressure (in the form of higher home prices). Bond yields, responding to the inflation pressure, rise to reflect fears of inflation.
Previously, we indicated this chart to suggest that inflation fears in the U.S. economy may be building. Now, however, it appears more likely that U.S. homebuilder stocks may be poised for a fall rather than two-year yields rising. (see chart)
The S&P Homebuilder Index has enjoyed an extraordinary jump from depressed levels. The index has appreciated by 81 per cent in the past twelve months. Today, there is considerable optimism reflected in the sector's trailing average price earnings ratio of 28 times. Analysts project year over year earnings growth of 35 per cent for the current quarter. Given the high levels of expectation and the likely significant unrealized profits for current shareholders, any company reporting slower than expected growth can expect to have its stock hammered in the aftermath.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.