House Builders: Trouble ahead

What is the implication for investors who hold shares in housebuilding companies?

Our long-term graph helps to put things into perspective. House building companies are an important component of the FTSE-Building & Construction sector. Their shares have steadily risen in the last two decades.

According to Thompson Financial Datastream, a £1,000 investment 20 years ago would have grown to almost £7,000 when shares peaked in mid-April, a compound annual growth rate of more than 10% per year.

Some experts claim house building shares often peak two or three years after the rest of the stock market turns down. The graph shows such claims are without foundation. UK shares peaked in December 1999 but sector shares continued to advance for the next four years. Another stock market downturn in 1990 saw house building shares begin to fall before the rest of the stock market. Dips in 1992, 1994 and 1998 saw house builders slip in lock step with the rest of the stock market.

Interest Rates

The graph also highlights several periods when interest rates were rising. Notice that shares invariably dip during interest rate up-cycles. It happened in 1988 to 1990 when rates rose from 7.3% to 14.8% (period A) and when rates zig zagged up from 5.1% to 7.5% in 1994 to 1998 (period B)

More recently interest rates rose from 5% to 6% in September 1999 to February 2001 (period C) and shares again dipped, right on cue.

So what lies ahead? Will sector shares soon resume their advance or are we near the start of a significant reversal? Obviously, there are no guarantees in the world of investing. But if the past is any guide, shares will not resume their upward trend until interest rates stop advancing. Judging from recent news reports, that stage in the cycle is some distance into the future.

Historical Trends

Long-term seasonal trends tell a worrying tale as well. Since 1977, prices rose in most years between November to April. This year followed the trend.

Unfortunately, history also teaches that sector shares typically do not perform very well from May to October. Since 1983, prices rose just four times from May to October and fell 17 times. Here too, there are no guarantees but the risk of sector weakness as mid-year approaches is quite evident. Thus far, 2004 appears to be following the norm.

Economic Factors

There are a number of conflicting forces in the economic and political arenas that pull investors in opposite directions.

On the positive side, the need for new dwelling units in the UK continues to out-strip supply. Demographers are quite certain underlying conditions that foster this trend like divorce and improving mortality rates will continue well into the future.

Sector bulls point to another positive clue about the future. Recent earnings statements from the house building sector are very strong. Many companies continue to report double-digit profit gains and rising dividends. Corporate executives see no sign of a slow down.

Finally, we must not forget that local Council restrictions on new housing have become a hot political issue. The government is taking steps to increase the supply of new housing, a good profit opportunity for builders.

But investors should also recall that housing prices fell sharply in the early 1990s in the face of similarly favourable demographic trends. And housing executives always seem to be quite bullish about sector prospects. Think back to their optimism in late-1989 and mid-1999, just before sector shares began to fall. The simple fact is that these chaps are a pretty optimistic lot.

On the issue of government action, keep in mind that national legislation will merely ease the planning approval process and free up additional land for development. It will not force house builders to build. If the market is not there, builders will not build.

The plain vanilla truth is that the economic and political forces cited above help to explain why prices got to current levels. They do not explain why prices will stay at these levels.

On the negative side of the ledger are the issues of first-time buyers and buy-to-let speculators.

The percentage of housing transactions accounted for by first-time buyers is at its lowest level for some years. First-timers are increasingly having difficulty in scraping together a deposit to enter the market. These buyers form the all-important bottom rung of the housing ladder, providing an exit route for those wishing to trade up. Their disappearance is a serious negative sign for the housing market.

Growth in the buy-to-let segment of the market is also worrying. Investors who entered this market early profited. But current entrants are facing higher purchase prices, higher carrying costs and a glut of rental competition that is forcing down rental income in some areas.

The vulnerability of buy-to-let investors is hard to ignore. A slow-down in buy-to-let purchases looks likely.

Bubbles

Many observers believe the recent explosive house price trend has the look and feel of a price bubble. If they are right, there are serious implications to consider. Although no one can predict when a bubble will explode, the aftermath is always the same - sales declines. There has never been an exception to this rule of thumb, in any asset class, country or century.

A bursting of the bubble will hurt house builders by reducing the number of houses being built and reducing their corporate profits.

Concerns about a bursting bubble would be less worrying if interest rates were low and plateauing. But we have already experienced four rate hikes in recent months and more are in the pipeline. By historical standards, current rates are still low. Even so, each up-tick in rates makes the typical variable-rate mortgage more expensive and reduces the number able to buy.

On balance, the weight of technical, historical and economic evidence helps to explain why housing sector shares have risen to their current levels and why the sector is vulnerable in the months ahead.