Home Depot and Housing Have Further to Run

Despite delivering two strong earnings reports, and raising  guidance in each of them, shares of Home Depot   have oscillated between $75 and $80 since June. As such, investors must be starting to wonder what exactly it's going to take for the stock to break out of its range.  

Moreover, if the naysayers are right, buying Home Depot or other housing-related stocks like Whirlpool , Masco, Williams-Sonoma  or Lowe's  could prove a costly error made at the peak of optimism over the housing market. 

The bear case
A pessimistic outlook sees the housing market as stalling at the altar of higher interest rates. In this scenario, the positive news that Home Depot and Lowe's have been reporting is merely a lagging indicator poised to follow the housing market lower in due course.

As this graph shows, both companies have been reporting much stronger same-store-sales growth this year.

Source: company presentations

Against this backdrop, there is no doubt that the housing market has endured a slowdown as a consequence of higher rates. For example, existing home sales have noticeably weakened since interest rates started rising.

Source: National Association of Realtors

If sales continue to weaken and drag home prices down with them, then the housing recovery could easily be snuffed out.

Housing trap being set?
If this scenario is correct, then stocks tied to the US housing market like Home Depot, Lowe's, Whirlpool, Masco, and Williams-Sonoma are almost perfect traps for growth investors. The trap will be sprung if they report strong results in the fourth quarter, as their demand tends to lag the housing market. Investors would then be induced to buy in, only to see their dreams crushed as housing turns downward in 2014.

Indeed, home-furnishings company Williams-Sonoma recently beat estimates and raised fourth-quarter guidance. Moreover, its growth platforms of Pottery Barn, West Elm, and PBteen recorded comparable-brand revenue growth of 8.4%, 22.2%, and 16.7%, respectively. These numbers are a clear indication of discretionary spending returning, but it doesn't stop there.

Building-products company Masco reported that its North American sales were up 12%, with faucet and toilet sales up "in the mid-teens." Masco's plumbing products are a good indicator of spending in the new-home-sales market, and in general, Masco is more geared toward new residential construction.

And finally, appliance-maker Whirlpool has progressively raised its expectations for full-year industry demand as the year has progressed.

Full Year Industry Demand Assumption	First Quarter	Second Quarter	Third Quarter
North America	2% to 3%	6% to 8%	9%
Europe	flat	flat to (2%)	flat
Latin America	3% to 5%	1% to 3%	1%
Asia	3% to 5%	flat	(2%)

Source: company presentations

All of these companies are reporting strong conditions, but is it all just a bear trap that's about to be sprung?

Rates are only part of the picture
Frankly, it would be a mistake just to look at interest rates in isolation. Moreover, the economy tends to behave like a supertanker--it has its own momentum and takes a while to turn around. Right now, employment remains in a steady growth mode, and usually when that happens consumers tend to feel more comfortable about spending.

In turn, financial institutions start seeing better conditions and lending opportunities, so they start to loosen lending criteria. A credit expansion follows, which then drives the economy onward. In usual recoveries, this is accompanied by rising interest rates because there is more demand for capital.

Indeed, Home Depot's management touched on the issue during its conference call when CFO Carol Tome said, "We've regressed ourselves both against 10-year Treasuries and 30-year mortgages, to see if there is any sort of correlation and we can't see it."  

In other words, the housing market isn't just dependent on interest rates. However, Tome did go on to say Home Depot monitored housing turnover (the rate at which houses are sold) and prices. She continued, " If home prices were to decline, then we might have a different point of view on the housing recovery".

The good news is that despite slowing existing home sales, US home prices are rising.

Source: S & P Case-Shiller

The outlook remains positive for housing.

The bottom line
While all of the companies discussed above have their own internal dynamics, the underlying question is the same: is the housing market about to stall or not? If you share the opinion that it won't, then Home Depot is probably the best pure play.

Lowe's is similar, but it also needs to deliver with its plan to reset its product sales. Masco gives you heavy exposure to new home construction. Whirlpool has significant overseas exposure and heavy competition in appliances, while Williams-Sonoma competes in some highly competitive markets too.