Why recovery growth of 2.5% should boost homebuilder stocks

Increases in gross domestic product, or GDP, measure economic growth

Gross domestic product is what’s referred to generally as “the economy.” It’s the sum of consumption, investment, and government spending. Another way to think of GDP is the output of goods and services produced by labor and property in the U.S. economy. This number is an estimate of growth. The U.S. economy is roughly $16 trillion.

GDPEnlarge Graph

The Bureau of Economic Analysis puts out three estimates of GDP growth after a quarter ends. The advance estimate is released within a month of quarter end, and it’s based on incomplete data or data subject to revision. The second is released after two months, and the third and final revision is released after three months.

Consumption is by far the biggest driver of GDP growth, and it accounts for something like 70% of GDP. The Fed’s quantitative easing program targets at consumption. If the Fed can lower mortgage rates enough that people can refinance, then they’ll have more disposable income and hopefully spend more. Investment is basically corporate investment in growth, also known as “capital expenditure.” Government spending is the final component.

Highlights of the Q4 release

The advance estimate of Q4 GDP showed GDP grew at an annualized pace of 3.2%. The first revision lowered that estimate by 0.8%, to 2.4%. The price index increased at 1.6% annually, an upward revision of 0.3%. This is still below the rate the Fed would like to see. Personal consumption expenditures were revised downward: 0.7% to 2.6%.

The effect of government spending is igniting a political debate in Washington. Certain economists are in favor of government spending increases in order to push economic growth. This is what’s known as “Keynesian stimulus spending”—when the private sector won’t spend, the government can step in and pick up the slack. Politicians on the left will point to the effect decreasing government spending has had on GDP growth. Politicians on the right will point out that government spending is roughly 24% of GDP—the highest since the Truman Administration.

Implications for homebuilders

Homebuilders are sensitive to the general economy, particularly the job market. GDP growth of 2.5% should be enough to slowly heal the labor market and increase the capacity utilization numbers. Stronger consumption numbers are clearly a good sign for them.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Lennar (LEN), Pulte Group (PHM), Toll Brothers (TOL), and D.R. Horton (DHI). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves. The secular (long-term) story for homebuilders is optimistic. Household formation numbers will be a real wind at their backs.

Homebuilding can become a virtuous circle for the economy, and this explains why the recovery has been tepid so far. Historically, homebuilders were the first to recover after a recession—construction and homebuilding usually led the economy out. This time around, that didn’t happen because of the shadow inventory, which meant that economic growth was more tepid during this recovery. But that appears to be changing.

To learn more about investing in homebuilders, see Why pending home sales ticked up, driven by move-up buyers.