We are on the brink of a potentially epic economic change.
Fortunately, this is unlikely to be a "black swan" event that rattles the markets from Main Street to Wall Street. It is also not likely to be a sudden shock that quickly dissipates, leaving everything about the same as before. I am talking about a fully controlled, incremental long-term shift that will forever change the economic landscape.
To prop up the U.S. economy after the financial crisis, the Federal Reserve used monetary tools such as dropping interest rates to the lowest levels in history and flooding the markets with ready cash and quantitative easing measures. Now that the economy is back on track, the Fed has signaled its intention to throttle back on quantitative easing, likely to the point of elimination.
In addition, interest rates have started to spike.
This is a long-term change that is currently in its infancy: the economy's reversion from a government-supported quasi-free market to the largely self-supported free market it was prior to the financial crisis. What this means is that we can expect interest rates to continue to increase.
With the Fed showing signs of easing its grip on interest rates, rates have nowhere to go but up. The everyday economy is feeling these rate increases in the mortgage market. The average 30-year mortgage rate has climbed to around 4.15%.
How Can Investors Capitalize On the Epic Change?
While there are many ways one might profit from rising interest rates, I like the idea of buying homebuilders right now. Yes, you read that correctly -- buying homebuilder stocks.
Obviously, rising interest rates are not a good thing over the long term for homebuilders. However, over the next year or so, rising rates should force aspiring homeowners into a purchase decision, spurring growth in this sector.
In other words, new homeowners who want to lock in rates while they're relatively low will do so sooner rather than later as rates inch higher. Fortunately, rates usually move incrementally rather than in big jumps. This incremental movement will allow time for homebuyers to make their move, while at the same time providing strong impetus for a rapid decision.
Supporting this theory, homebuilder confidence hit a seven-year high in June, with a reading of 52, according to the National Association of Homebuilders/Wells Fargo Housing Market Index. Any reading over 50 indicates more builders are positive about sales condition than negative. June marked the first time since September 2002 that the index has advanced as many as 8 points.
Homebuilder stocks are reflecting this optimism being well off their lows while setting up for potential buys. In fact, homebuilder stocks have strongly outperformed the broad market. Over the past year, the S&P Supercomposite Homebuilding Index has soared more than 60%, compared with about a 22% gain in the S&P 500. Not to mention that the National Association of Homebuilders forecasts total housing starts will rise 29% this year from last year.
Add in the powerful buying impetus of rising rates, and the homebuilder sector should continue to outperform. Here are my two favorites.
Hovnanian Enterprises (NYSE: HOV)
This residential homebuilder boasts a market cap of over $880 million with a total enterprise value of $2.45 billion. With year-over-year quarterly revenue growth of nearly 24%, annual revenue of $1.6 billion, and a trailing 12-month gross profit of more than $214 million, Hovnanian has a solid balance sheet.
In the technical picture, HOV has just slipped from its high, creating a channel entry opportunity. I like this stock on a breakout above resistance in the $6.40 area or a breakdown to support in the $5.80 range.
Lennar (NYSE: LEN)
This homebuilder boasts a market cap of over $7 billion with a total enterprise value of more than $11.4 billion. Lennar's financials are solid: year-over-year quarterly revenue growth of nearly 37%, annual revenue of more than $4.3 billion, and trailing 12-month gross profit of close to $600 million. Net earnings climbed to 26 cents a share in the latest quarter from just 8 cents in the same quarter last year. Operating margins improved by more than 4% in the same time.
Technically, the price of LEN, although off its lows, has fallen into a channel, creating potential buy setups. I like this stock on a breakout above the upper channel line in the $39.50 range or a breakdown to the lower channel at the recent lows in the $37 area.
Risks to Consider: The government's withdrawal of its massive economic support programs will have long-term implications for everyone. Although rising interest rates could well spur would-be homebuyers into purchasing, high interest rates will probably have negative effects on homebuilders. Remember, we are in uncharted territory economically. Use caution when making any investing decision, and always use stops and position size properly.
Action to Take --> I like both Lennar and Hovnanian right now provided the entry parameters listed. My 12-month price targets are $8 for Hovnanian and $44 for Lennar.