NEW YORK (CNN/Money) -
Tuesday was an ugly day to own homebuilding stocks.
First, there was an earnings warning from Washington Mutual, which said that its mortgage-origination business has dropped off sharply. Then, there was that statement from the Fed suggesting that it's beginning to slouch toward higher rates.
So not only is housing cooling, investors surmised, it's going to get colder. And so they scuttled shares of outfits like Centex (CTX: Research, Estimates), which dropped 4.7 percent, and Pulte (PHM: Research, Estimates), which fell 4.6 percent. Toll Brothers (TOL: Research, Estimates), which easily beat analyst earnings expectations when it reported Wednesday morning, tumbled 5.2 percent.
Small wonder. Selling these stocks as the Fed goes into tightening mode has always been a good idea. When rates rise, housing activity slows and homebuilders are left holding the bag. In 1994, when a series of hikes sent the fed funds target rate up sharply, the homebuilding group fell over 40 percent. And considering how well the homebuilders have done this year (many have doubled in price) one can hardly question the wisdom of investors who want to take some off the table.
But a repeat of the 1994 experience isn't set in stone.
First off, valuations on these stocks are much lower now. KB Home (KBH: Research, Estimates), for example, carries a price-to-earnings ratio of 8.1 compared with the P/E of 24.2 it had right before the Fed's first rate hike in early February 1994. Toll Brothers, the most expensive stock in the group, has a P/E of 12.5 now compared with 23.3 back then.
Furthermore, there are signs that the homebuilders have gotten out of the classic boom-and-bust mode that held them in the past. Smith Barney analyst Stephen Kim has pointed out that many smaller players, which tend to overbuild during the flush times, have been pushed out of the market, and as a result inventory levels have come down. This means that when housing growth slows, there won't be the same sort of fire sale we've seen in the past.
But though the group may be better able to withstand higher rates, this is a theory that hasn't been tested out in practice. Homebuilders continue to hold much lower valuations than the rest of the market because investors fully expect them to blow it again -- and of course, that may be the right call. But if the companies can weather a rate rise well, then they could be in for a period of P/E multiple expansion.
And then when investors consider how the builders made it through the most recent recession unscathed while other companies faltered, the stocks could go higher still.