Forget The Pullback — This Sector’s Doing Great

Even after a horrendous January and amid the bear market talk dominating the financial news, I remain bullish on the stock market. I will even so far as to say that one interest rate-sensitive sector that thrived in 2013 will continue its winning ways into next year.#-ad_banner-#​

There is no question that January was a difficult month for the stock market. A combination of the Federal Reserve starting to dial back on its massive bond-buying program, emerging-market fears and even the end of Ben Bernanke’s term as Fed chairman fueled investor anxiety. In addition, interest rates started a slow climb higher, prompting an overreaction on the sell side. 

Uncertainty is stocks’ #1 enemy. Seeing as some of the past month’s uncertainty has been realized, I think the overall downward price trend will soon stabilize, forcing stocks back into their long-term upward drift. 

But rather than speculate about the future, let’s look at what actually occurred in the first month of 2014, with the Dow Jones Industrial Average as a guide. 

After hitting an all-time high near 16,600 at the end of December, the Dow dropped to just under 15,700 by Jan. 31. Yet it’s crucial to remember the Dow was at 14,800 just four months ago.

A bear market is defined as a pullback of 20% or more. That means the Dow would have to sink all the way to 12,560 before stocks enter a bear market. That means retreating back more than a year and a half, to mid-2012. From this perspective, last month’s sell-off doesn’t appear as ominous as the bear market pundits might believe.

On the fundamental side, the U.S. economy grew 3.7% from July to December and 3.2% in the fourth quarter alone. That puts the last six months of 2013 among the best-performing six-month periods of the past decade. Economists point to healthy consumer and business spending and stronger exports as the catalysts for the growth. 

This growth is the reason why the Fed is dialing back on its bond-buying quantitative easing (QE) program, which it said last week it will taper by another $10 billion a month, to $65 billion. In other words, the program is working: The Fed is reducing its buying because the economy is managing the difference. And we haven’t even mentioned that the economy’s growth in the second half of last year took place in the face of a partial government shutdown in October, political budget battles and the uncertainty over the Affordable Care Act (aka Obamacare).

In my view, the only real bearish fundamental fact is the specter of rising interest rates. Climbing interest rates tend to slow economic growth, so they’re generally have bearish effect on the long-term stock market. However, in the case of the housing sector, the fear of climbing rates spurs buying. 

Rising rates provide a very strong incentive for homebuyers to act before rates climb higher. When rates are dropping, prospective homebuyers tend to procrastinate, often waiting for lower rates. Now that the fear of climbing rates has hit the market, homebuyers are being forced to act quickly. 

Fear, paradoxically, is a good thing when it comes to the housing sector. Keep in mind, I’m talking only about the start of rising rates, perhaps two years after the slow and arduous rate lifting process begins. After this time, higher rates will likely start to weigh on housing. 

The ideal way to profit from the improving housing market is by homebuilder exchange-traded funds (ETFs). 

Many investors believe that the homebuilder market is overheated right now. Although it was due for a pullback, this has already occurred — along with the entire market — last month. Now is the time for the interest rate fears and overall improved bullishness to lift the homebuilders higher. My reasons include the above, plus these three:

The S&P/Case-Shiller report of home prices: The benchmark 10- and 20-city indices showed prices grew by nearly 14% in November from a year earlier. Prices fell slightly in November from the preceding month, but this is a seasonal trend. Overall, prices were the highest for November since 2005. This is a very bullish sign.

Forecasts: The National Association of Realtors has forecast a 40% increase in new-home sales this year. That is an aggressive figure, and if it proves even halfway correct, homebuilders will thrive this year. 

Earnings: One example of improving homebuilder numbers is D.R. Horton (NYSE: DHI), which just posted an 80% year-over-year increase in earnings in its fiscal first quarter, with home sales up 33%.

Risks to Consider: Homebuilders soared higher in 2013. Although there has been substantial profit-taking in the first month of this year, the potential remains that that selling may continue despite my bullish reasoning. Be sure to use stop-loss orders and diversify when investing.

Action to Take –> Investors can certainly purchase the individual homebuilders, but I prefer the S&P Homebuilders Index ETF (NYSE: XHB) to invest in this sector. This ETF reduces single-company risk while providing exposure to the sector as a whole. Buying now in the $31 to $31.75 range with stops just below $30.50 and a 2014 target price of $35 makes solid investment sense.

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