Don't Give Up on US Housing Just Yet

It's not often that a company beats estimates and raises guidance only for the stock to be promptly sold-off by investors. Clearly, in the case of Home Depot (NYSE: HD  ) , the market is pricing in some future macroeconomic uncertainty.

The company's recent earnings were excellent, and gave no cause for the sell-off. The most likely explanation is that investors are starting to fear the future impact of rising rates on the housing market. So is this a buying opportunity in the stock, or is the market right to be concerned?

Home Depot hits a home run

In the second quarter, Home Depot recorded its first double-digit sales increase in over 13 years, and raised full-year earnings and revenue guidance. Indeed, the latter event is becoming a pretty good benchmark for improving conditions within the US housing market.

source: company reports

Clearly the US housing market is doing well this year, but recent rate rises and a fall in new home sales data for July has highlighted the potential dangers in housing. Conditions may well be fine now, but if this turns out to be the peak then buying into home-improvement stores could prove to be a mistake.

Moreover, the valuations on Home Depot and Lowe's (NYSE: LOW  ) suggest that both companies need an ongoing housing recovery in order to move higher from here.

Home Depot P/E Ratio trailing-12 months data by YCharts

If you put these arguments together, it is easy to start beginning the case that Home Depot's prospects have peaked and the stock could fall from here.  Is it really that simple?

Why it's not time to panic

There are four main reasons why investors shouldn't give up just yet.

Firstly, while rising rates will affect housing affordability, according to historical data, buying a house via a mortgage is still affordable. For example, here is the NAHB and Wells Fargo (NYSE: WFC  ) housing-opportunity index.

Source: national association of home builders

It is an index that Wells Fargo investors should follow closely, since the bank runs over 20% of the US mortgage market. The index may well have peaked, but continued job gains and increases in average household wealth will help to mitigate the effects of rising rates on the index.

Indeed, Wells Fargo needs an improvement in new mortgage origination because higher rates are slowing refinancing activity. In response, the bank is taking measures to boost lending, but the ultimate guide to its fortunes will be how the housing market fares in future.

Secondly, homeowner vacancy rates remain low and close to historical norms.

Source: united states census of the bureau

This is a pretty good indication that the housing recovery has legs, because it implies that there isn't an oversupply of properties on the market. The figures are nowhere near the kind of vacancy rates reached from 2006 through 2011.

The third reason is that the economy doesn't just turn on a dime. The US economy is growing (albeit moderately), and investment in housing isn't just a function of interest rates. In fact, rates tend to rise when the economy is getting better, and banks tend to start loosening credit standards when the economy improves. Moreover, job gains will add new potential home buyers to the marketplace; all of which are good for the housing market.

The final reason is that the Federal Reserve is watching! For all the talk of tapering quantitative easing, the truth is that Ben Bernanke always outlines that tapering is contingent upon the economy improving. Since housing is a key part of the economy, it is reasonable to expect that the Federal Reserve will do what it takes to keep mortgage rates low.

The bottom line

The market is right to fear some affect from interest rate rises, but the housing market has too much momentum behind it to fall away anytime soon. Investors in Home Depot and Lowe's should look forward to ongoing improvements in end- market demand.

While Home-Depot is more of a pure-play on housing, Lowe's also has upside from its internal restructuring. The latter is trying to reset its sales lines with a view to increasing inventory turnover. Lowe's is executing well on its plans, but its usually easier to do such things when end-markets remain favorable. In other words, both companies are still likely to see their prospects dictated by the housing market.

With the market seemingly determined (in the short term) to price in some future weakness in Home Depot, it looks like a good opportunity to pick up some stock.

It's Time to Worry About China

There are two ways of looking at developments on the macro-economic front.

The first is to take a top down approach and analyze as much economic data as you can get your hands on. The second is to build up a macro view by aggregating knowledge from looking at a large number of micro sources such as company earnings.

In this article I want to do the latter and look at what a few companies have been saying about current conditions in China. The issue is highly significant because the global economy is reliant on China to generate growth this year.

Government changing or is it a deeper issue?

The key question about current conditions in China is whether the slowdown is a temporary one brought about by the change in Government (as businesses/consumers wait to see the policy changes) or whether it is a deeper problem relating to structural problems in the economy. It is true that the Government has the resources to ‘buy’ its way to GDP growth closer to 8% but will it do so? Moreover will it chase 7.5%-8% growth even if it involves pumping investment into corrupt or non-competitive channels? Even at the expense of inflating a bubble in housing?

The big fear with China’s real estate market is that it is being inflated by liquidity being pumped into the economy (partly from its foreign currency reserves) which has few other mature investment vehicles with which to attract investors. This puts the government in a difficult situation. Should it buy growth at the expense of inflating a property bubble or stand and watch as the economy possibly gets weaker?

What the companies are saying

The most interesting thing about Oracle’s (NASDAQ: ORCL) recent results was the diversity in its geographic results. Its Americas results were pretty much in line with expectations while EMEA was actually slightly above its expectations'. Oracle came in with new license growth at 4% and 5% respectively in these regions.

The big surprise geographically speaking was that the Asia region was down 7% in terms of new licenses. China was cited as being weaker and, interestingly, Australia was particularly weak too. Moreover Brazil was stated as having pulled down growth in the Americas. These two countries are significant because they are commodity-heavy economies which rely on exports to China in order to grow. Since Oracle spoke to continuing ‘to see pressure in China’, I think it is more than a short term issue. The good news from Oracle's perspective is that China is not a huge part of its current sales.

Turning away from technology, I thought industrial filtration company Pall Corp (NYSE: PLL) had some interesting things to say in its recent results. I have looked at them in more depth here. Again, its big weakness in the quarter was from-you guessed it-China. It described many of the markets that it had historically sold into as being ‘down year-over-year’. Indeed its Asian sales were down 11% with China being particularly weak.

Pall’s challenges relate perfectly to the changing nature of growth in the regime. The Chinese stimulus packages will not be about pumping money into heavy industrial and infrastructural projects designed to develop its export laden manufacturing facilities and more about stimulating internal demand. Ultimately this means disruption to companies like Pall who got used to selling to the exporters.

On a broader perspective I think FedEx Corp (NYSE: FDX) gave some fascinating color on the changes in the global economy. Just a few years ago it used to generate the bulk of its profits from its express services but now the big income generator is its ground services.

Going back to 2997, its express services generated nearly 61% of operating income but that fell to around 22% in the last year. Meanwhile its ground services contributed 25% of income in 2007 but it has now risen to 70% now. This perfectly represents the changes in the global economy whereby slow growth has led customers to shift to lower priced (and slower) ground services in the face of a world with $100 oil prices.

In addition, management never fails to point out that global trade growth has been lower than global growth over the last few years. This reflects the structural changes in consumer demand from the Western consumer world which ultimately will lead to slower export growth in China.

Such issues have created operational issues at FedEx as it was geared up for international growth in its international express services. It was a growth that never came and over the last couple of years it has been restructuring and taking impairment charges as it retires unnecessary aircraft and routes. Indeed its big upside opportunity is to generate cost savings in express going forward.

The bottom line

Putting these results and commentary together paints a picture of some short term weakness plus some structural issues in China. Investing in the types of heavy industrial plays on China that worked so well in the past isn’t going to be the best option anymore and there are question marks over the viability of China’s plans to shift to a more consumer orientated economy.

It’s time to be a little cautious over China.