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The Ratings Game: Mortgage rates should keep falling, boosting home-builder stocks, analysts say

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Shares of home builders enjoyed a broad rally Wednesday after BofA Securities said it sees a “favorable setup” for the sector, with lower mortgage rates on the horizon.

Analyst Rafe Jadrosich said that after the home-builder sector underperformed in 2022, with demand deteriorating in the second half of the year as mortgage rates more than doubled, he’s still cautious on housing demand, especially in the first half of 2023, amid macroeconomic concerns.

However, Jadrosich has several reasons for believing home-builder stocks won’t wait for demand to bottom out before they start rallying:

Mortgage rates likely peaked in 2022 and are poised to move lower in 2023.

Valuations in the sector indicate weak demand, and home-price declines are already priced into the stocks.

Home prices are expected to correct, falling about 10%, but because of tight supply, low vacancy rates and pent-up demand, prices aren’t likely to crash by 15% to 20%.

Lower costs, helped by falling lumber prices, should provide a boost to home builders’ profit margins. Continuous lumber futures
LB00,
+3.52%

have tumbled 66.2% over the past 12 months.

“Macro is a concern, but housing demand and builder valuations are already at recessionary levels, and we expect the inflation and rate backdrop to be more important for stock performance in 2023,” Jadrosich wrote in a note to clients.

The iShares Home Construction exchange-traded fund
ITB,
+0.51%

climbed 1.6% in midday trading, with 46 of 48 components trading higher. That outperformed the S&P 500’s
SPX,
+0.40%

0.5% gain.

Shares of Toll Brothers Inc.
TOL,
+0.21%

went up 2.7% and shares of PulteGroup Inc.
PHM,
+0.85%

jumped 1.8% after Jadrosich upgraded both builders to buy from neutral, and Lennar Corp.’s
LEN,
-0.33%

stock tacked on 1.3% after he raised his rating to neutral from underperform.

Elsewhere, NVR Inc.’s
NVR,
+1.18%

stock gained 1.3% after Jadrosich reiterated his buy rating but raised his price target to $5,500 from $4,900. Jadrosich said NVR was his top pick in the sector, as the stock has historically outperformed its rivals in a rising-rate environment and in periods of weak home sales.

BofA’s Jadrosich wasn’t alone Wednesday in being upbeat on home builders in the coming year.

The biggest gainers in the home-construction ETF were shares of TopBuild Corp.
BLD,
+4.37%
,
which rose 5.2%, and Installed Building Products Inc.
IBP,
+4.13%
,
which advanced 4.6%, after Deutsche Bank’s Joe Ahlersmeyer upgraded both companies to buy from hold.

With interest-rate risk “now seeming to drift favorably,” Ahlersmeyer said he is now “far more constructive” on stocks with new-residential-construction exposure.

“[W]e sense a growing optimism around the recovery path for housing, which could drive relative multiples back toward levels more consistent with a mid-cycle environment, even if demand for new homes were to simply demonstrate some stabilization,” Ahlersmeyer wrote.

After plunging 26.9% in 2022, the home-construction ETF has gained 7.7% so far in 2023. In comparison, the S&P 500 is up 2.6% year to date after dropping 19.4% last year.

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