Ignore warnings about a potential housing bubble and consider these stocks with bright outlooks

Other housing sector experts worry that rising mortgage rates will damage sector growth. If higher rates spark a slowdown, it’ll hurt everyone since home building is such a big driver in our economy.

Related: These stocks loved by analysts let you tap into the hot housing market

But should we really be scared? I don’t think so.

True, it’s troubling that home prices shot up 10% last year, and we can expect the same increase this year. Such rapid price gains can suggest a bubble is in the works. Buyers continue to aggressively chase scarce supply, another warning sign. The average existing property sells in just 16 days, points out Bank of America.

But here are four reasons why this doesn’t portend problems ahead for the economy or even housing stocks, for that matter.

1. Lenders and borrowers aren’t going crazy

Lenders are following much stricter underwriting standards compared to 2006-2008, says Federal National Mortgage Association (FNMA) chief economist Doug Duncan. So the kind of excesses that created the financial crisis are not in the cards.

2. Mortgage rates are near historic lows

Wannabe homebuyers are no doubt peeved that the 30-year fixed mortgage rate has shot up to 3.2% from an average of 2.8% in the fourth quarter of last year. That seems like a big negative for potential buyers. But really, it’s not that bad. After all, this mortgage rate is still well below the 7.3% average since 1982, points out Mortgage Bankers Association economist Joel Kan. “I don’t expect this to be major stumbling block for anyone buying a home,” he says.

Adam Ballantyne, a senior analyst at Cambiar Investors, agrees. “Mortgage rates remain near record lows for the past 60 years, more than offsetting the home price gains and cost of ownership,” says Ballantyne, who follows the housing sector for Cambiar.

A big risk is that a sharp rise in inflation sends 10-year Treasury yields higher, driving mortgage rates up. But this is unlikely for several reasons, including productivity gains.

Fannie Mae predicts fairly tame inflation of 1.8% to 2.2% during the second half of this year through the third quarter of 2022.

3. Demand for homes will exceed supply

Duncan, the Federal National Mortgage Association economist, expects home prices to rise another 10% this year. He cites these underlying supply-demand imbalances:

The supply of existing homes for sale is at all-time lows. The level of new homes sold and not constructed is at all-time highs. And the supply of homes under construction or built and available for sale is at very low levels.

What explains this?

Boomers, for one. They are not downsizing and leaving homes at the pace of prior generations, says Duncan. One reason is they’re healthier, for their age. Next, millennials are moving into peak home-buying age. Third, the robust economy ahead will bring solid jobs growth. Combined with the high savings rate, this will support demand. Next, rents are strengthening again, which drives people to consider home ownership.

“Order activity in February and March, heading into the spring selling season, is still at multi-decade records for larger homebuilders,” says Ballantyne, at Cambiar Investors.

Survey work confirms that home buyers aren’t about to take a break. Fannie Mae’s Home Purchase Sentiment Index, based on a poll of consumers, increased by 5.2 points in March to 81.7. The percentage of respondents who said it is a good time to buy a home increased to 53% from 48%.

4. Insider activity suggests no bubble exists

There’s a lot of insider selling by execs and directors at homebuilders, which is typical for the group. But by my calculations, it’s nowhere near the frenzied levels seen ahead of the financial crisis, which signaled trouble on the way. Consider the three largest homebuilders by revenue.

At Lennar
LEN,
-1.93%,
insiders sold an annualized $11.9 million worth of stock in the last two quarters. That’s nearly half of the $21.5 million per year worth they sold in 2005 and 2006, the years before the financial crisis started to hit. At Pulte
PHM,
-1.02%,
the annualized selling in the past two quarters was just $791,000 compared to $3.4 million a year in 2005-2006.

At D.R. Horton
DHI,
-1.25%,
recent selling surpassed pre-crisis selling by two to one. That does look troubling. But it’s offset by the more favorable ratios at Lennar and Pulte, and the large insider buying I recently spotted at the real estate developer Howard Hughes
HHC,
-0.97%
and PennyMac Financial Services
PFSI,
+0.99%,
a mortgage originator.

Homebuilding stocks to consider

Ballantyne, at Cambiar, thinks homebuilder stocks will outperform the market in 2021, even though most homebuilder stocks are at all-time highs. Just don’t expect the gains we’ve seen in the last three quarters. “Most of the easier money has been made, as much of the growth in earnings is already priced in,” he says.

But more profits are possible in these names, because stock valuations remain exceptionally low. Consider D.R. Horton, for example, the largest homebuilder. It’s posting some of the largest earnings growth in its history (43% last year, and 50% expected this year). But its stock trades at a forward P/E of 10.3, which is closer to the bottom of its 10-year historical P/E range of 8 to 15, says Ballantyne.

Home-builder valuations also remain exceptionally low versus the broader market, despite the solid backdrop for the group, he says. The bullish backdrop in his view: Demand remains exceptionally high; supply remains exceptionally low; and affordability is still very good. Homebuilders are also in good shape because of lower debt levels, record high margins, and solid cash flow growth, he says.

Bank of America has “buy” ratings on D.R. Horton, KB Home 
KBH,
-2.67%
and Forestar Group
FOR,
+0.73%
in homebuilding and real estate development. JP Morgan
JPM,
-0.60%
analyst Michael Rehaut has “overweight” ratings on D.R. Horton, PulteGroup and M.D.C. Holdings
MDC,
-2.59%.
He predicts these companies will benefit from solid 2021 demand. Keefe, Bruyette & Woods, a division of Stifel, has “buy” ratings on Toll Brothers
TOL,
-1.73%
and Lennar
LEN,
-1.93%.

In home-building supplies, Bank of America has “buy” ratings on Masco
MAS,
-1.08%,
Armstrong World Industries 
AWI,
-1.72%
and JELD-WEN Holding
JELD,
-1.69%.

Two ‘insider’ plays

I personally favor Howard Hughes, because of the repeat insider buying — its executives are buying the stock. This real estate developer is a “double” since I suggested it in my stock letter, Brush Up on Stocks (see the link in my bio, below) at around $50 in April 2020. I just reiterated the stock in my letter at current levels, in part because of more insider buying, and I continue to own this name.

Howard Hughes purchases land in high-growth regions in Nevada, Maryland and Hawaii. It preps the land for development and sells it to homebuilders, who create communities. Then Howard Hughes builds offices, shopping centers and restaurants on the nearby land that it keeps to serve the communities. It’s also a reopening play because of its development in the Seaport District on the East River in Lower Manhattan.

Insiders also really like PennyMac Financial Services, a mortgage originator. Mortgage market growth will cool in 2021, but it will still be strong by historical standards. Home purchase mortgage originations will grow by 10%, while refinance originations will decline. That dynamic shouldn’t be a negative for PennyMac Financial, since it focuses on mortgage originations for home purchases instead of refinancings.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned HHC. Brush has suggested HHC, JPM and TOL in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.