Homebuilder Trading Strategy (Backtest And Example)

Last Updated on October 14, 2022 by Oddmund Groette

The homebuilder industry has changed a lot in recent years, with large builders that are listed on the stock market increasing their share of the market. Want to know about the homebuilder industry?

The home building industry is made up of companies that build new homes that customers buy and live in them. As heavily cyclical stocks, homebuilder stocks are dependent on a strong economy for growth. Until recently, they have been out of the investment spotlight as a result of the real estate crash during the Great Financial Crisis, and the 2022 market downturn may be set to hit it hard again.

In this post, we take a look at the homebuilder industries, and we end the article by showing you a backtested homebuilder strategy by using XHB (the ETF for the homebuilder sector).

What is a homebuilder?

The homebuilder industry in the US is made up of large public companies that are engaged in residential construction.

Apart from the large, publicly traded companies, there are other small private companies that operate in most parts of the US but they are mostly focused on a particular niche in the market, such as entry-level homes or luxury homes. The larger builders also focus on a particular niche, but in comparison to the private companies, tend to have access to debt and equity financing methods to pursue larger construction projects. These companies tend to expand their businesses and buy smaller builders in a period of economic boom.

The revenue growth of homebuilders is highly associated with the appreciation in real estate prices, so in a booming real estate market, homebuilders tend to see more revenue as there is more demand for new homes.

Real estate has increased, on average, by 5% annually for over a decade. But what makes the homebuilder industry stand out is that it is not as saturated as the real estate industry, so there is more room for growth.

However, there are many factors to put into consideration for this industry, which are important for investors in other to understand if you are going to invest in the stocks of publicly traded homebuilders.

Some of the factors affecting the prices of homebuilder stocks can be correlated to the prices of land, which raise the cost of production for homebuilders. There is also the typical 4.5% annual increase in the cost of labor, which could pose a greater threat to revenue generation in the industry. Inflation also makes the cost of getting raw materials higher, reducing homebuilders’ profits. These and many more are some of the things to consider before investing in the industry.

One more thing, the homebuilder market is cyclical, and during periods of economic downturn, customers may be hard to come by. If you want to invest, do so only during before periods of economic boom, it might be too late when the boom-fever is high.

How big is the sector?

As of 2022, the market size of the US homebuilding industry by revenue is $129.3B. This ranks the industry at the 8th position. Compared to the overall construction sector, the homebuilding market size has increased significantly, averaging about a 5% annual return over the past decade.

The spending on public residential construction is around $9.06B, while the value of new private residential buildings put in place stands at $517.57B. So, a significant driver of revenue for the homebuilder industry is household growth. It has been projected that the spending on new residential construction will increase to $1.05T in 2026.

Listed homebuilder companies

Some of the leading companies in the homebuilder industry are:

  • D.R. Horton ($DHI). D.R. Horton is the largest homebuilder company by volume in the US in 2022. It was ranked 194 on the 2019 list of largest 500 corporations by revenue in the US according to Fortune 500. The company generated $27.8B in revenue as of 2021.
  • Lennar Corp ($LEN). Lennar Corp. is the second largest homebuilder company in the US based on the number of homes sold in 2019. The company ranked 129th on the 2021 list of Fortune 500 with a revenue of $27.13B.
  • NVR, Inc. ($NVR). NVR Inc. operates as a home construction company in the US. It also has a title service and mortgage banking business arm. Its main operations are usually on the East Coast of the US, but it also has operations scattered across the countries.
  • Pulte Group ($PHM). Pulte Group Inc. is based in Atlanta, Georgia, US. It is the 3rd largest residential construction company in the US based on the number of home sales. The company has built over 600,000 homes to date.
  • Toll Brothers ($TOL). Toll Brothers is the fifth-largest home construction in the US. It designs, constructs, markets, sells, and finances residential and commercial properties in the US. It is ranked 411th on the Fortune 500.

By the time you read this article, the list above might be different. The stock market is extremely dynamic and companies come and go. To better understand why we recommend reading Do Stocks Outperform Treasury Bills? (Not What You Expected).

Homebuilder trading strategy backtest

Let’s backtest a homebuilder trading strategy with specific trading rules and settings. We use the ETF with the ticker code XHB, a highly liquid ETF that tracks homebuilders. Thus, this is an XHB trading strategy.

Please keep in mind that many of the traditional mean reversion indicators don’t work well on the homebuilder sector. We can only speculate on the reasons for that, but the sector is very sensitive to interest rates and is highly cyclical. Thus, we find the sector pretty difficult to trade and we currently don’t trade the sector ourselves.

And to make matters worse, trend-following strategies don’t work well either!

Why is the homebuilder sector so difficult to trade?

We believe the reason is mainly that it’s very exposed to random and volatile macro factors. Housing is extremely sensitive to the interest rate, for example. From the all-time high in early 2022, a period of rising rates, XHB has fallen almost 40%, much more than the overall market.

Let’s backtest a simple mean reversion strategy on XHB:

  • When the 2-day RSI indicator is below 10, we go long at the close.
  • We sell at the close when the 2-day RSI is above 80.

The strategy is a bit like our old RSI SPY trading strategy we published almost ten years ago.

The equity curve for our XHB trading strategy looks like this:

Homebuilder trading strategy
XHB trading strategy. Homebuilders suffer from large drawdowns.

There are 191 trades, the average gain per trade is a solid 0.83%, and the win rate is 71%, but the max drawdown is very high at 50%.

It’s the latter (drawdowns and losses) that is always a problem with very volatile sectors like the homebuilders: losses mount once in a while. You can have a long series of gains until you hit a big loss.

We recommend to focus on sectors that we regard as much better suited for trading: our favorite sectors are consumer staples (XLP) and utilities (XLU).

Other sector trading strategies

We have covered all the different subsectors of the S&P 500:

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