This Super-Cheap Industry Is the Epitome of a Value Trap

When the curtain closed on 2018, Wall Street and investors were left with their first year of losses, inclusive of dividends, since 2008. Had it not been for a four-day, end-of-year rally, things could have looked much worse.

There were no shortage of concerns roiling the markets last year. These included the (ongoing) trade war between the U.S. and China, the flattening of the yield curve, the Federal Reserve's continued hawkish stance on monetary policy, and President Trump's public criticism of Fed Chair Jerome Powell. Many of these worries aren't going away simply because the calendar has switched over to 2019.

The one dirt cheap industry to avoid like the plague in 2019

How will Wall Street and investors respond? My guess is that we'll see a move into value stocks for the first time this decade. But this, too, brings its own set of risks. So-called value stocks could appear "cheap" on the surface, but have numerous fundamental flaws with their business model. If investors aren't careful, they could fall victim to a value trap.

In 2019, there are plenty of great value stocks for investors to choose from. Then again, there's also one industry that looks to have all the telltale signs of being a value trap. Don't shoot the messenger, realtors, but the residential construction industry (you might know them best as "homebuilders") looks like one to avoid like the plague this year.

Just how cheap and alluring are homebuilders on a fundamental basis? According to market analytics firm Yardeni Research, the S&P 500 had a forward price-to-earnings ratio of 14.5 as of Dec. 20, 2018. That was its lowest reading in about four years. Meanwhile, homebuilders had a forward P/E of 7 on the same date. Yes, seven. That's the lowest forward P/E for this industry since the midpoint of 2006! Some well-known builders within the industry, such as Beazer Homes (NYSE: BZH), Lennar, and KB Home, have forward P/Es of between four and six in fiscal 2019.

But there are a handful of alarming warning signs that strongly suggest investors avoid homebuilders.

Americans are spoiled

One of the biggest red flags for the homebuilders are rising interest rates. Even though mortgage rates aren't directly tied to the Fed's monetary policy, the 10-year Treasury note is usually viewed as a gauge for where mortgage rates will head next. In recent weeks, a drop in 10-year Treasury yields brought the 30-year mortgage rate (the most popular of all term loans for homebuyers) back to 4.55%, as of Dec. 27, 2018. But this is unlikely to last.

The Fed has indicated that another two quarter-point hikes (i.e., 25 basis points each) are likely in 2019, which would push the federal funds target rate to 3%. This is widely expected to lift the yield on the 10-year Treasury note and push 30-year mortgage rates above the 5% mark on a recurring basis for the first time since early 2011.

You might be thinking that a 5% mortgage rate still sounds like a great deal -- and I assure you, it is on an historic basis. But that's not where we are as a homebuying society. We've been spoiled with sub-5% 30-year rates for more than a half decade thanks to an historically accommodative Fed between December 2008 and December 2015. Even though 30-year mortgage rates have moved up only between 100 and 150 basis points over the past two-and-a-half years, refinancing applications have fallen by more than 60% over that period, and mortgage applications for new and existing single-family homes are at more than a three-year low.

The data has shown that it doesn't take much of a move up in mortgage interest rates to send prospective homebuyers back to the sidelines. That's great news for apartment real estate investment trusts, which lean on rental increases to drive additional funds from operations, but terrible news for homebuilders.

The economics of supply and demand are worrisome

Prior to the housing bubble of 2007, homebuilders got themselves into big trouble by oversupplying the market. Just like any good or service, the economics of supply and demand matter. If there's more demand than supply, the price of a good or service would be expected to rise. In contrast, if supply outweighs demand, prices tend to fall.

Why does this matter? Data from the U.S. Department of Housing and Urban Development shows that the seasonally adjusted monthly supply of houses rose to 7.4 months in October 2018. That's a big increase from the 4.9 months of supply from a year earlier in November 2017. Not counting the Great Recession, we have to go all the way back to 1989 to find a monthly supply of homes figure this high that wasn't tied to a recession. In general, a supply figure this high is a precursor to recession.

And if you don't believe this macro data, take a look at what's happening in America's most followed housing market: California. According to a report from CNBC, new and existing home and condominium sales in September 2018 fell 18% year over year. The decline was particularly noticeable for new homes, which were 47% lower than their September average, dating back 30 years. Year-over-year median home prices also registered their slowest uptick in three years.

Homebuilders could choose to build more affordable housing rather than risk pricing prospective buyers, who are already on the fence due to rising mortgage rates, out of the market. However, none appears to have made that choice as of yet.

Fiscal policy discourages new homebuyers

As the icing on the cake, the passage of the Tax Cuts and Jobs Act in December 2017 limited the scope of the mortgage interest deduction. Previously, mortgage interest on loans of up to $1 million could be claimed by taxpayers. This was reduced to $750,000 by the Tax Cuts and Jobs Act, which could have a negative impact for small property investors and homebuyers in higher-priced housing markets. Mind you, this only applies to mortgages taken after Dec. 15, 2017, so existing homeowners prior to this date are grandfathered into the old cap of $1 million.

Homebuilders aren't as attractive as you think

And if this still isn't enough to push you to the sidelines, lift the hood on some of these homebuilders. In many instances you'll be terrified, or at best disappointed, with what you find.

The aforementioned Beazer Homes, which primarily offers homes in the Southwest, Southeast, and Mid-Atlantic region, ended its most recent quarter with $1.23 billion in debt, just under $140 million in cash, and has generated a meager $30.3 million in operating cash flow over the trailing-12-month period. Even with record-low mortgage rates, Beazer Homes wasn't able to deliver significant operating income. Now, with industry metrics beginning to turn south, Beazer sports a forward P/E of just 4. Any investor who lifts the hood on Beazer is bound to find these red flags. The key point being that investors have to take the time to look for these warning signs.

While I can't say this with any certainty, the housing market is giving off all the telltale signs of a substantive downturn, if not a recession. It's the epitome of a value trap, and it's to be avoided at all costs in 2019.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.