<December 27, 2023>
Christmas parties are often entertaining. They can go in many directions depending on who you meet and speak with. During a recent neighborhood party, I was fortunate to be introduced to a local contractor focused on residential renovations and new construction. We talked in depth about the housing market. He informed me business was booming and that he doesn’t have an opening to quote new projects until July. I asked when he thought things would slow, and he quickly exclaimed, “Never!” For an extremely cyclical industry, never is a very bold prediction!
It’s been a fascinating housing market. Despite the sharp rise in mortgage rates, home prices refused to correct this cycle. In fact, since the Fed began raising rates, prices in aggregate have increased. The tight job market, inflated asset prices, and below average home inventory contributed to the market’s resilience.
As homeowners cling to their low-rate mortgages, the supply of homes for sale has remained low. With fewer FOR SALE signs lining the streets, homebuilder operating results have held up well, and in some cases, improved. Several homebuilders have also benefited from stronger pricing discipline, choosing profits over production (Make Less Make More).
Toll Brothers (TOL) is one of the companies using price to improve margins and returns. With an average selling price of $1.03 million, Toll Brothers targets higher-end buyers. The company is currently benefiting from the “have and have not” economy and the growing share of wealthy all-cash buyers. In our view, Toll Brothers’ results are influenced more by movements in the Nasdaq 100 than 30-year mortgage rates! With the stock market and household wealth booming, Toll Brothers is generating record earnings. Gross margins have been particularly impressive and are currently the highest since the last housing bubble.
During Toll Brothers’ most recent conference call, management called results terrific. And they were. In addition to generating record EPS, return on equity reached 22.8%. Management noted, “We accomplished these results despite mortgage rates reaching generational highs, global unrest, gridlock in Washington and fears of a recession.”
Toll Brothers also provided a positive outlook. Management believes they are “set up nicely for the upcoming spring selling season” with inflation easing and the potential for further declines in interest rates. Assuming mortgage rates decline as expected, management believes they’ll “be able to raise prices” and “modestly reduce incentives.” Optimism is high.
Toll Brothers’ earnings report was released before the Federal Reserve’s December 13, 2024, meeting, and press conference. The company was expecting an exceptionally strong year even before Chairman Powell hinted at cutting rates and the 10-year Treasury yield took another leg lower.
As we wrote in past commentaries (You’ll Know We’ll Have a Good Time Then), we expected the Federal Reserve would eventually cave and revert to its easy money ways. However, we didn’t expect it at the end of the year, and only two weeks after Powell said rate cuts weren’t being discussed. As Powell gave investors the green light, year-end performance anxiety spiked, contributing to a stampede into risk assets.
The timing of Powell’s pivot (before option expiration and year-end bonuses) reminded us of Alan Greenspan and his surprise rate cuts, often timed to maximize the impact on financial markets. Shifting policy as stocks traded near record highs was also surprising, supporting the belief that Powell doesn’t view asset inflation as inflation.
In addition to the unexpected timing, we were surprised Powell pivoted with home prices so high and out of reach by so many. As Toll Brothers indicated earlier this month, trends were already supportive for further increases in prices. The industry didn’t need to be turbocharged heading into the all-important spring selling season. Post-pivot, home prices will likely accelerate, causing prices relative to incomes to expand further. While lower mortgage rates may soften the blow, the housing affordability crisis is not going to be solved by easing monetary policy and more housing inflation.
The Federal Reserve typically considers rate cuts when asset prices are declining, or the economy is weakening. That is not the case today. By pivoting preemptively, we believe the Fed is attempting to protect asset prices and the economy from a sustained period of positive real rates. However, instead of simply protecting prices, it has unleased another wave of asset inflation, jolting bond and equity prices higher. With home inventory limited, interest rates declining, unemployment low, and stock prices soaring, we believe there is a growing risk of a spring crack-up boom in home prices. If Toll Brothers was optimistic earlier this month, they must be giddy now!
As is often the case during the later stages of asset bubbles, we believe we’ve reached a point where higher home prices do more harm than good. While the current environment is favorable for homebuilders, another leg-up in prices would be very troublesome for the millions of Americans already priced out of the housing market. If Powell’s pivot was politically motivated, we believe it could backfire as finger pointing related to wealth inequality and housing affordability intensifies. There was also finger pointing and debate after the last housing bubble. Who was to blame? Culprits included banks, Wall Street, the Fed, mortgage brokers, government-sponsored enterprises, appraisers, speculators, and rating agencies. This time around there won’t be any debate, in our opinion. Chairman Powell made sure of that on December 13, 2023.
Eric Cinnamond
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Definitions:
The Nasdaq 100: A stock market index with the 100 largest, most actively traded companies listed on the Nasdaq stock exchange.
S&P Case Shiller Home Price Index: The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated monthly. It is included in the S&P CoreLogic Case-Shiller Home Price Index Series which seeks to measure changes in the total value of all existing single-family housing stock.