Relative Weakness In Financial And Homebuilder ETFs

Americans are at it again. They are becoming wide-eyed at the prospect of real estate riches, convinced by media cheer-leading that the 2007-2009 collapse in home prices was a once-in-a-century anomaly.

Why shouldn’t we be enthusiastic? Home values have been rising by double digit percentages. Buyers are tripping over themselves to outbid one another. And when the vast majority of participants still fail to understand leverage, they are easily persuaded by the promise of 100% paper gains on 20% down.

Yet the stock market has a way of detecting problems long before they start. Take a look at 2007 — a year when the stock market eked out a respectable gain on low volatility, but the SPDR Sector Select Financial Fund (XLF) had declined dramatically. In essence, the investment community had already sniffed out the flattening of real estate prices, the waning of housing affordability and the bursting of a mortgage bubble.

Perhaps ironically, XLF maintained a modicum of relative strength over thee broader market benchmark (SPY) in 2006. Yet, as higher mortgage rates and higher home prices combined to push affordability out of reach, even with the rosiest of loan underwriting assumptions, XLF demonstrated eye-popping relative weakness by 2007. And the rest (2008-2009), as they say, was history!

Flash forward to 2013. Over the last 10 weeks, XLF has gone from a remarkable outperformer to a definitive underperformer. Even the recent down tick in mortgage rates from roughly “4.75% for 30 years” to 4.25% for 30 years” has not served as comfort for big financial firms. Many of them have laid off workers in anticipation of ongoing weakness in financing and refinancing of real estate.

Already, banks have been working overtime to put a terrific spin on upcoming earnings. They’ve lowered estimates in advance, so that they might still beat “expectations” in Q3 reports. Nevertheless, the extraordinary drop in mortgage volume challenges the ability of CEOs to provide strong guidance going forward. The Fed may still have the stock market’s back, but will it be able to push financial stocks back into the lead? Right now, the only sector with worse performance over the prior 3 months is the consumer staples segment.

Could history be serving as a guide here? In 2007, long before the broader S&P SPDR Trust (SPY) felt the sting of a global collapse, iShares U.S. Home Construction (ITB) fell into the proverbial toilet.

Not surprisingly, since the Federal Reserve discussed tapering its bond-buying policy back on May 22, higher mortgage rates have slammed the home construction segment. Whether the pain lasts or not may depend on how long and how much the Fed intends to manipulate rates going forward.

Bill Gross of PIMCO fame has hinted that interest rates will be lower for far longer than the market has currently priced in. I can’t say that I disagree with him. Japan has been able to snooker the world with quantitative easing (QE) for 12 years. To this day, Japan’s economy cannot manage a clean exit from unconventional rate manipulation… and I am not convinced that the U.S. can either. Even when we exit unconventional policy, we’re likely to stick with a 0% federal funds rate for most of the current decade. Even if we attempt to raise rates, we’ll probably come right back down to 0% and usher in QE6, QE 7 and QE8.

The question is, will Federal Reserve stimulus coupled with modest employment growth be able to support a housing recovery that can last… or will we see housing struggle with more frequent bouts of price deterioration? I think the latter is more probable. And while I will not actively short financials or short the homebuilders, I see little reason to be excited by these ETFs. (At least not until “taper talk” shifts to extending QE3 or starting QE4.)

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.