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LA Wildfires and Housing Crisis: What It Means for Homebuilding Stocks
On Tuesday, January 7, I stepped outside my apartment in Venice Beach, Calif., and noticed smoke coming from the Santa Monica mountains.
I texted a friend who lives in Santa Monica, closer to the smoke. She snapped this photo from her roof.
We were watching the early hours of the “Palisades Fire.”
Along with the Eaton Fire and other blazes, these flames would ultimately destroy over 11,500 homes across 60 square miles, with total real estate losses expected to exceed $30 billion.
Understanding the Housing Crisis in Los Angeles
Before the fires, Los Angeles neighborhoods already faced a significant housing shortage. The demand for homes far outpaced the available supply.
As basic economics suggests, high demand combined with low supply leads to soaring prices.
With the overnight loss of 11,500 homes, the situation worsened significantly.
Though state and local laws prohibit price gouging, many landlords are raising rents. A surge of rental requests has led to affluent applicants willing to pay significantly more than the market rate. In the Palisades neighborhood, where the average home price nears $4 million, this trend is particularly evident.
As reported by The Los Angeles Times:
People are desperate, local agents said.
Their homes are in ashes, and they’re looking for stability — somewhere for their family to go that’s not a shelter, a friend’s house, or a hotel room.
Some landlords are now sharply raising rent, even beyond what temporary price gouging protections allow.
And some would-be renters are offering a year’s rent upfront in cash and engaging in bidding wars.
This situation seems unlikely to improve soon.
A National Perspective on Home Sales
Across the United States, a similar supply and demand imbalance exists, but it is driven by different factors. Instead of wildfires damaging homes, inflation has eroded the purchasing power of potential buyers, pushing home prices even higher.
Federal Reserve data indicates trends in the average price of houses sold in the U.S. dating back to 1960, highlighting the dramatic spike during the pandemic.
Source: Federal Reserve data
Currently, with a 30-year mortgage rate near 7%, the housing market remains stagnant.
Recently, CNBC reported:
The U.S. housing market continues to weaken, as potential buyers face stubbornly high mortgage rates, high prices, and limited supply of listings.
Sales of previously-owned homes fell 4.9% in January from the prior month to 4.08 million units on a seasonally-adjusted, annualized basis, according to the National Association of Realtors. Analysts were expecting a 2.6% decline.
Sales…are still running at a roughly 15-year low.
This scenario would typically bode well for homebuilding stocks. Up until recently, that has been the case.
A Look Back: Homebuilding Stocks Performance
Long-time Digest readers may recall our unofficial focus on homebuilding stocks, particularly in 2022.
In our April 20, 2022, Digest, we recommended that aggressive investors initiate a trade on the iShares Home Construction ETF, ITB. This fund includes major builders such as DR Horton, Lennar, NVR, Pulte, and Toll Brothers.
From that point until ITB’s peak in October, the trade rose by 119%, outperforming the S&P 500.
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Analyzing ITB’s Recent Decline: A Strategic Buy or Sell?
Market Dynamics Offer Mixed Signals for Homebuilders
Since its peak, ITB has faced a significant decline of around 25%.
Frequent readers of the Digest know I prioritize using stop-losses to guard gains. So, is it time to sell ITB?
If your instinctive response is “yes,” consider the current state of the housing market.
Given today’s economic conditions, could they be exceptionally favorable for homebuilders? If so, does ITB’s 25% drop present a strong buying opportunity?
The Challenges Facing Homebuilders Today
Presently, homebuilder companies are navigating a complex marketplace.
High prices for existing homes suggest strong demand for new construction. Intuitively, one might expect builders to respond by increasing their production to capitalize on this demand.
However, the situation is more complicated.
During the pandemic, prices for materials such as lumber and concrete surged and, although some have declined, many remain high, squeezing profit margins.
Additionally, there is an ongoing shortage of skilled construction labor, which means higher wages, further impacting profitability.
Land acquisition and development costs have also risen due to increased interest rates, adding another layer of financial strain.
Consequently, builders face difficulties in undercutting current market prices while still safeguarding their profit margins. The situation is not as lucrative for them as it might initially appear.
It’s also crucial to note the effect of near-7% mortgage rates, which have significantly impacted housing affordability.
Nonetheless, if the Federal Reserve reduces interest rates this year, and with aging Baby Boomers needing to downsize and sell their homes, could these factors mitigate the supply-demand imbalance?
Do such potential developments turn this ITB sell-off into an opportunity for investors?
While speculation is one approach, we can lean on historical market data from TradeSmith to guide our decision.
Eliminating Uncertainty in Investment Decisions
For those new to the Digest, TradeSmith is a research partner of ours.
This investment research company focuses on data-driven insights and is committed to continuous improvement through extensive research and development efforts.
Over $19 million and over 11,000 hours have been invested to build advanced market analysis algorithms, supported by a dedicated team working on their software and data systems.
One of their systems is designed for timing market entries and exits.
Last week, we discussed how TradeSmith’s CEO, Keith Kaplan, will be hosting a live event this Thursday to demonstrate this tool.
Let’s apply it to ITB.
Before delving deeper, let’s take a conceptual approach.
Considering ITB is down about 25% from its peak, is this a moment to sell, or should you double down?
Keith remarked on a broader scale: “Investors are risk-seeking when we’re losing.”
This situation probably resonates with many investors. You might say to yourself:
- I’m buying this on the dip.
- This stock will bounce back, lowering my average cost.
- It’s just a paper loss.
However, what you may be doing is increasing risk by holding or buying more of a declining stock.
Keith emphasizes that momentum is key in investing.
A stock in a confirmed uptrend is more likely to continue rising, while one in a confirmed downtrend is likely to fall further.
This principle seems straightforward: buy when a stock rises and sell when it falls. Yet, the reality is more nuanced.
How can one discern whether a stock’s pullback is part of a “confirmed downtrend” or just a temporary pause before a new upward trajectory?
TradeSmith provides a solution to this question.
Measuring Volatility Quotient (VQ)
It’s important to note that volatility is not synonymous with risk, and it varies across different stocks.
To illustrate, consider two companies: Coca-Cola (KO) and Matador Resources (MTDR), which operates in oil and gas exploration.
Both stocks saw approximately 17% growth from October 2021 to mid-April 2022, but their paths varied greatly.
As shown in the chart below, Matador’s path is shown in red and Coca-Cola’s in blue.
Source: TradingView
Coca-Cola exhibited a smoother growth trajectory compared to Matador’s more volatile fluctuations.
As a result, applying the same trailing stop-loss percentage to both stocks overlooks the crucial distinction in their respective volatilities.
This understanding can heavily influence investment decisions and risk management strategies moving forward.
Understanding Volatility: Assessing Your Investment in ITB Stock
A stock labeled as “riskier” doesn’t necessarily mean it’s a bad investment. Investors simply need to consider its higher price fluctuations while determining how much to invest and setting stop-loss orders.
TradeSmith has developed a tool that quantifies these fluctuations, known as the “Volatility Quotient” (VQ). This reading assists investors in understanding what level of volatility is typical for a given stock, fund, or cryptocurrency.
Keith from TradeSmith explains:
[The VQ number] solves so many problems that individual investors face today. Certainly, people like me, and likely you as well.
It provides insights into historical and current volatility – or risk – associated with a stock, fund, or crypto. The focus is on the price movements of these assets.
Here’s what it reveals (I’ll stick with stocks for simplicity):
- When to purchase a stock.
- How much of a stock to acquire.
- When to sell a stock.
- And how volatile that stock is – what price swings to expect.
Examining ITB’s VQ for Current Insights
Below is a snapshot of ITB as of last Friday, sourced from TradeSmith’s data.
Let’s take a closer look at the specifics shortly. Here’s the data page to start with:
Source: TradeSmith
The red “H” marks the October high for ITB. This figure is important as it corresponds with ITB’s VQ reading.
Given this high point and ITB’s specific VQ, the recommended stop-loss level for the stock was set at $98.95, about 23% lower than its peak.
The green band at the bottom of the chart reflects a favorable performance that continued until mid-December, indicating it was still safe to hold ITB during that timeframe.
However, as ITB’s price began to decline, the color changed from green to yellow on December 18. This shift didn’t suggest an immediate need to sell but did imply caution, indicating a weakening upward trend.
Fast-forward to last Friday when ITB closed at $98.11, falling below the established stop-loss of $98.95. Consequently, in the Digest, we are closing our unofficial position yielding a gain of 69%.
Evaluating Future Potential amidst Economic Factors
There is the possibility that ITB might bounce back as 2025 approaches, but no one can predict with certainty. Current data, however, indicates weakness, which might persist in the near term.
Keith emphasizes a key principle:
The trend is your friend.
If the upward trend is confirmed, hold your position. Conversely, if it’s clear that a downtrend is underway, it’s wise to limit losses.
For those still interested in the housing market, Keith’s timing tool can signal when conditions shift and ITB enters a new bullish trend. Alerts can be set to notify you about these changes, allowing for re-evaluation of your investment at that time.
While speculating about inflation, interest rates, and housing demand is tempting, relying on hard data tends to yield better results.
Explore Keith’s Upcoming Session on Market Insights
If this approach resonates with you, consider attending Keith’s detailed session on this quantitative tool this Thursday at 8:00 PM ET. During this event, he will unveil a new technological advancement—the MQ algorithm—designed to mathematically identify market surges.
Keith will share insights from examining 5.2 billion data points, covering over 125 years of market history for the S&P 500, Nasdaq, and Dow. He will disclose the algorithm’s forecast for the coming 12 months at no cost during this session. Click here to register today.
As for ITB, it’s been a profitable endeavor, but for now, we’re stepping back.
Have a good evening,
Jeff Remsburg
