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Are Homebuilders Telling Us the Worst Is Over?

Heading into the second trading week of 2023, I wouldn’t have thought that the homebuilder industry was hitting ten-month highs. For the majority of last year, this group severely underperformed the market. Yet here we are, with homebuilders continuing to rally into the new year in the face of elevated mortgage rates and declining housing data.

Zacks Investment Research
Zacks Investment Research

Image Source: Zacks Investment Research

The Zacks Building Products – Homebuilder industry has returned nearly 20% over the past three months, handily outpacing the market. This group has made a series of higher highs despite a negative earnings outlook.

The National Association of REALTORS® recently reported that pending home sales slid for the sixth straight month in November, recording the second-lowest monthly reading in 20 years. Only the onset of the pandemic marked a lower reading. The Pending Home Sales Index, which is based on contract signings, fell 4% in November from October’s reading.

Worse yet, on a year-over-year basis, pending sales plummeted 37.8%. And just last month, homebuilder sentiment dropped to a 12-month low, marking the lowest reading in more than a decade.

This all begs the question: Why are homebuilder stocks rallying?

We all know that the market is forward-looking. Perhaps a drastic housing downturn simply won’t come to fruition as supply remains low, and rate hikes are closer to an end than a beginning. But a deeper look reveals another possibility: valuation.

Homebuilder stocks shed nearly 40% of their value from peak to trough during this bear market, and many individual companies are relatively undervalued. This could a correction to the upside, with these stocks simply returning to more normal levels after an extreme move to the downside.

One well-known homebuilder that has led the charge during the recent rally is Toll Brothers TOL. TOL is currently a Zacks Rank #3 (Hold) stock, and is ranked favorably by our Zacks Style Score categories, with a best-in-class ‘A’ rating in our Value and Growth categories.

Toll Brothers has exceeded earnings estimates in each of the past four quarters, with an average surprise of 14.99%. The community home developer most recently reported Q3 EPS last month of $4.67/share, a 20.4% surprise over the $3.88 consensus estimate. Sales of $3.71 billion also surpassed estimates by 15.4%.

Zacks Investment Research
Zacks Investment Research

Image Source: Zacks Investment Research

TOL stock has advanced more than 30% since the October low. Even with the impressive bounce, shares are trading at just a 6.77 forward P/E. Despite recent positive earnings estimate revisions, analysts are expecting a gloomy 2023, with full-year EPS expected to decline -21% to $7.84/share.

Perhaps this is a bear market rally in homebuilder stocks. Or, the group may be rallying as future earnings estimates (and valuations) remain too low. One thing’s for sure – homebuilders are an important group to watch as we kick off the second trading week of the year.

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Zacks Investment Research