Why sentiment for homebuilders like Lennar jumped in July

The National Association of Homebuilder Sentiment Index: A closely watched measure of future building activity

The National Association of Homebuilders Sentiment Index measures homebuilders’ confidence. It gauges builder perceptions of current and future sales of single-family residences and asks builders to characterize the sales as “good,” “fair,” or “poor.”

It also asks the builders to rate the prospective buyers’ traffic as “high to very high,” “average,” or “low to very low.”

Why sentiment for homebuilders like Lennar jumped in July

An index level of 50 is considered neutral. The index peaked at 71 during the height of the housing bubble—late 2005—and bottomed at eight in early 2009. While the index has been steadily rising in the years since it bottomed, it has now begun to accelerate.

Homebuilder sentiment rebounding and approaching post-recession highs

The index came in at 53—an increase from 49 in June. Builder sentiment peaked last summer and had fallen to the mid 40s over the winter and through spring. The economy actually contracted in Q1. So it looks like builders are confident that the slowdown was a weather-driven, temporary phenomenon and not the beginning of a recession.

Builders are in a good position right now, with tight inventory. They’re able to increase margins, as virtually every builder reported higher gross margins, and drive revenue by increasing prices.

Most market watchers expect home prices to moderate next year. But that would require extra supply. In the Northeast, that may be possible, as the foreclosure pipeline is still full. In the red-hot West Coast markets, builders still seem to be cautious about overbuilding.

A shortage of skilled labor has been a problem for the homebuilding industry as well as the mortgage industry. Since the bubble burst, employment in these sectors dropped so dramatically that many skilled workers found jobs in other sectors of the economy. Skilled construction workers were absorbed by the energy sector and trucking.

Implications for homebuilders

Shortages of construction materials, lots, and skilled labor may mean that gross margins for the builders like Lennar (LEN), D.R. Horton (DHI), PulteGroup (PHM), and Toll Brothers (TOL) have peaked. Virtually every builder reported record or close-to-record gross margins, as prices have risen faster than input costs. From what the report has to say, those days may be over.

That said, volumes should increase as the economy recovers and more pent-up demand is released. At some point, demographics will take over. 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 Homebuilder ETF (XHB) didn’t really react to the news. As the job market improves, the first-time homebuyer should reappear. This would create a wind at homebuilders’ backs.