Must-know: Why a positive ISM is bullish for homebuilder stocks

Market Realist

Key December 2013 Institute for Supply Management Index updates (Part 2 of 4)

(Continued from Part 1)

Implications for homebuilders

Manufacturing activity is a good sign for job growth, which has been the Achilles’ heel of this recovery. Although manufacturing isn’t the driver of the economy that it used to be, it still matters. Having a level of manufacturing that corresponds to 4.6% GDP growth is certainly a positive.

Some of the commments from the survey participants include:

  • “Largest backlog ever. Most orders waiting on customer approvals.” (Fabricated metal products)
  • “Markets are sound. We typically see a seasonal 4th quarter slowdown. However, this year… not so.” (Wood products)
  • “Construction equipment market continues to be flat with some signs of improvement on the horizon.” (Machinery)

The construction comment was interesting, but we’re in a seasonally weak period for construction, and we’ve seen that private construction has been strong but public construction has been weaker.

Secular story for the homebuilders

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Standard Pacific (SPF), Lennar (LEN), KB Home (KBH), Meritage (MTH), and Ryland (RYL). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves. This can create a virtuous circle in the economy, as increasing demand raises prices, which reignites the wealth effect and increases consumption. The secular (long-term) story for homebuilders is optimistic. Household formation numbers will be a real wind at their backs.

Could margins contract going forward?

On the other hand, the shortage of skilled workers could negatively affect margins as business expands. Lennar mentioned this concern on its second quarter conference call, although it considered it to be a blessing in disguise, as higher employment and higher wages will drive consumer confidence and growth. That said, the report noted that raw material prices are increasing, but homebuilders still reported pricing power and margin expansion. An uptick in raw material pricing or labor costs could negatively affect homebuilders, but so far, margins are generally strong.

Continue to Part 3

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