Home-Builder ETFs Launch
Into a Softening Housing Market

Wall Street often tries to cash in on investors' tendency to chase the latest hot trend, as evidenced by the technology and Internet funds launched in the run-up to the 2000 dot-com crash.

However, in the case of exchange-traded funds concentrated on the home-construction industry, asset managers may be behind the curve.

The first ETF focused on homebuilders recently began trading and another is in the works. The timing of the launches seems dubious, however, with the housing market losing strength after a prolonged bull run.

"We're seeing early signs of a softening housing market," said Brad Sorensen, senior sector analyst at the Schwab Center for Investment Research. "This housing boom was longer-lasting and more inflatable than previous ones, but the cycles are similar."

Supported by low mortgage rates and strong housing demand, homebuilder stocks have churned out steady profits and big gains to investors in recent years.

Yet the homebuilder group, as measured by the Dow Jones U.S. Home Construction Index , has slid more than 17% since hitting record highs in late July.

Several factors are weighing on the sector. Perhaps most importantly, mortgage rates have steadily risen over the past year in the wake of consecutive Federal Reserve interest-rate hikes, with the benchmark 30-year fixed-rate mortgage average hitting 6.37% last week, according to Freddie Mac.

Additionally, the stocks plunged earlier this month after luxury homebuilder Toll Brothers Inc. lowered its outlook for 2006 home deliveries, partially blaming slack demand in some markets.

Slumping consumer confidence and growing inventories of homes for sale are other concerns. This past week, the National Association of Home Builders said its confidence index fell to its lowest level in 30 months.

Also, the Commerce Department reported new construction of U.S. homes, while still strong, fell 5.6% in October from the previous month, while building permits, which foreshadow future activity, dropped 6.7%.

"We believe a lack of affordability, driven by unsustainable price increases given income growth, will be the key constraint that softens [housing] demand," wrote analysts at Goldman Sachs in a research note late last week.

Past the peak?

With many analysts cautious about the housing market and future homebuilder profits, the timing of the launch of the PowerShares Dynamic Building & Construction Portfolio ETF, which began trading on the American Stock Exchange in late October, appears questionable.

Bruce Bond, president of the fund's sponsor PowerShares Capital Management, said the firm sees interest in a homebuilder ETF from both the long and short sides. Since ETFs trade like stocks, investors can profit from a downturn or hedge their exposure to the sector by going short.

"There are people who think the bubble is going to pop, and other investors think the rally still has legs," Bond said, noting that PowerShares doesn't have an outlook on the sector.

Apart from builders such as Toll Brothers and D.R. Horton Inc., the PowerShares ETF also invests in home-improvement retailers such as Home Depot Inc. and Lowe's Companies Inc.

Another asset manager, Boston-based State Street Global Advisors, has filed with regulators for more of a "pure play" ETF with a fund tracking an index of homebuilding companies managed by Standard & Poor's. That fund is expected to launch next year, pending regulatory approval.

There's little consensus on whether the pullback in homebuilder stocks that began this summer is the beginning of a prolonged slump or an opportunity to buy shares at a discount.

Some bullish analysts claim that valuation multiples for the builders are unjustifiably low because the sector has become less cyclical. Meanwhile, executives of large, publicly traded homebuilding companies say profits can grow even in down periods through expanding market share. Favorable demographics, heavy backlog of homes awaiting construction, easier access to capital to back acquisitions, and expertise in getting entitlements and building permits in a tougher regulatory environment, also auger well for the big builders, the bulls say.

Yet a bearish drumbeat is difficult to ignore. Scott Simon, head of the mortgage group at money management giant Pimco, said "a combination of declining affordability and Federal Reserve interest-rate increases will slow the housing market in 2006."

Added Sorensen at Schwab: "Inventory is building and it's taking longer to sell houses. The spread between the prices sellers are asking and what buyers are willing to pay is rising, which is an early sign of a softening market."

Email your comments to rjeditor@dowjones.com.