Wall Street contemplates a January taper while big banks compete

Part 5

Week in review: Why we’re seeing a tale of 2 housing sectors

The ten-year bond is the basic driver of REITs and homebuilders

Long-term interest rates are priced off the benchmark long-term bond, which is the ten-year Treasury. These days, the ten-year bond reacts to economic data through the Federal Reserve’s asset purchase program, also known as quantitative easing (or QE). As a general rule, economic data that shows weakness is bond bullish (positive). However, data that shows strength isn’t necessarily bond bearish (negative).

Housing startsEnlarge Graph

Retail sales and housing starts

Last week, we had some important economic data points, starting with retail sales. The headline number was an increase of 0.2%, but when you strip out the volatile gasoline and autos, sales increased 0.7%—a good number. On Friday, we got some news for the housing sector, with a housing starts number just shy of a million, and building permits approaching a million as well. We also had slightly better than expected industrial data, with industrial production and capacity utilization showing manufacturing continues to recover.

Homebuilder earnings and M&A

We had earnings from Lennar (LEN) and KB Home (KBH) recently. Lennar’s numbers were strong, while KB Home missed. Toll Brothers (TOL) reported good numbers the week before. The homebuilding segment has definitely been a case of two sectors—the luxury sector, which is doing extremely well, and the first-time homebuyer sector, which is getting bombarded from increasing real estate prices, increasing interest rates, and a lousy job market.

We’re starting to see mergers and acquisitions (M&A) activity in the homebuilding space, with two deals. First, Tri Pointe Homes (TPH) is buying Weyerhaeuser’s homebuilding unit, and second, Toll Brothers is buying Shapell. We can attribute much of this to the two-tiered financing market in general. Large companies like those in the homebuilder ETF (XHB) are able to borrow at exceptionally low interest rates and almost have money thrown at them by the Street. Smaller builders, however, are stuck dealing with the banks, and credit is much tighter for them.

Implications for mortgage REITs

Mortgage REITs, like Annaly (NLY) and American Capital (AGNC), are driven by interest rates. The mortgage REITs have been crushed as the ten-year bond has sold off, but they’ve been trying to form a bottom here. For REITs, it’s all about the Fed’s exit of QE (quantitative easing). In his post-FOMC press conference, Ben Bernanke told the market to expect a reduction in pretty much every FOMC meeting, with the normal caveats that everything is data-dependent.

Implications for homebuilders

Homebuilders, like Lennar (LEN), KB Home (KBH), and Standard Pacific (SPF), are more sensitive to general economic strength. Lennar reported strong earnings last week, while KB Home missed estimates. Right now is a slow time, and builders are getting ready for spring selling season, which unofficially starts after the Super Bowl.

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