The iShares U.S. Home Construction ETF (ITB) is on fire, up over 30% year to date. This is much more than a short-term move driven by speculation – the rally in ITB is built on solid fundamentals, and the ETF looks well-positioned for sustained gains going forward.

The Fundamentals Look Strong

Before we try to understand the current situation in the housing market, it is important to understand where we are coming from. After the housing bubble exploded in 2008, housing starts have been well below average during the past decade.

ChartData by YCharts

Markets generally work like a rubber band, and excess in one direction can lead to subsequent excesses in the opposite direction. It is not just that new supply has been below average for a long time, but demand is also set to explode higher due to the millennial generation entering their prime home-ownership age.

Source: Ned Davis Research

Source: Ned Davis Research

The global pandemic has caused a sharp recession, but it has also driven interest rates to historic lows. Authorities at the Federal Reserve have repeatedly said that they are planning to keep rates low for several years, and this obviously makes mortgage rates cheaper and houses more affordable.

In the words of Lennar (LEN) CEO Stuart Miller:

With historically low interest rates, and the production deficit that has defined homebuilding from the past decade, together with the limited inventory and short supply in the market, housing and especially affordable housing is and will continue to be an essential driver of the economy

It is not just about supply and demand dynamics. The pandemic is also making people increasingly conscious about the importance of the home, which is now also the office, the school, the gym, and the entertainment center. The pandemic is going to be over sooner or later, and life will go back to normal to a good degree, but we can also expect some permanent changes due to these very unusual times.

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Many corporations have ventured into work from home, and they have fine-tuned their technologies and processes to make it work smoothly. Work from home is clearly not the ideal scenario for all workers in every industry, but it can be very efficient and cost-effective in many particular cases. We are going to go back to school and to the gym in the middle term, but learning and exercising from home are not going to disappear like a fad.

The U.S. home ownership rate has exploded higher recently.

ChartData by YCharts

The pending home sales numbers just crushed expectations last week.

ChartData by YCharts

Importantly, supply is very tight right now. This should allow homebuilders to deliver attractive revenue growth rates, while also generating healthy profitability in a market with low inventory.

Chart

Data by YCharts

A Good Time To Buy

The ITB chart looks quite compelling. Like the rest of the market, the ETF bottomed in March and has been in a strong uptrend since then.

More recently, while many of the broad market indexes have pulled back in the past month due to massive political uncertainty and fears of new waves of coronavirus contagions, ITB has remained resiliently strong, with the 50 days moving average acting as support in the short term.

Even more interesting, the ETF is breaking above resistance levels at $57 and making new historical highs in recent days. On the back of solid fundamental data from the housing sector, ITB is both making new highs and outperforming the market by a considerable margin.

Source: TOS

In order to assess the timing conditions in ITB from a quantitative perspective, we can consider the Global Rotation strategy. This is a quantitative strategy that picks 3 ETFs among a group of more than 30 ETFs based on volatility-adjusted returns over the past 3-6 months. Winners tend to keep on winning more often than not, so the strategy intends to outperform the market by betting on the ETFs that are delivering superior risk-adjusted returns.

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The chart below shows the historical performance of the strategy since 2007. The portfolio holds the top 3 ETFs based on risk-adjusted returns, and it is rebalanced monthly. The benchmark is a 60/40 portfolio of global stocks and bonds. The strategy gained 615% since 2007, far surpassing the 120.5% produced by the benchmark in the same period.

Source: ETF Replay

The annual return for the strategy is 15.4% versus 5.9% for the benchmark. More importantly, the maximum drawdown, meaning maximum decline from the peak, is 18.4% for the strategy versus a maximum drawdown of 35.4% for the benchmark.

Source: ETF Replay

If we compare the Global Rotation strategy versus a buy-and-hold position in the SPDR S&P 500 Trust ETF (SPY), the strategy beats the index-tracking ETF by a wide margin too. The annual return is 15.5% for the Global Rotation strategy versus 8.6% for SPDR S&P 500, and the maximum drawdown is less than half, 18.4% for the strategy versus 55.2% for SPY.

Source: ETF Replay

Providing more context, the table below shows returns for the Global Rotation strategy versus the benchmark since January 2007. The biggest advantage that the strategy has is that it made big gains in years such as 2008 by investing in safe haven assets like bonds and gold while stocks were getting crushed. It is quite exceptional to have a strategy that can gain 15.5% in a year in which the benchmark declined 19.5%.

In years such as 2017, when stocks are booming, investing in high-beta sectors such as technology can also produce superior returns for a trend-following strategy such as Global Rotation.

On the other hand, in years such as 2015 or 2019, when relative performance trends were short-lived and rather weak, a strategy such as this one generally delivers mediocre returns and it typically underperforms the benchmark.

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Source: ETF Replay

In simple terms, the Global Rotation is based on finding outperforming ETFs and riding the trend until it ends. If the trend is strong and long-lasting – either up or down for stocks – the strategy will most probably deliver very attractive returns. On the other hand, in periods when trends are weak and short-lived, returns will generally be disappointing.

The point is that ITB is one of the top 3 ETFs picked by the quantitative strategy based on risk-adjusted performance over the middle term. Not only is the ETF looking very strong on its own merits, as it is making all-time highs in a volatile market environment, but it is also one of the best ETFs in the market across a wide variety of instruments when considering relative risk-adjusted momentum over the middle term.

Past performance does not guarantee future returns, but momentum is a pervasive force, meaning that strength begets more strength in the stock market. When considering both the main fundamental drivers and the timing indicator, it makes sense to consider a long position in ITB at this time.

The Global Rotation Strategy is updated monthly in The Data Driven Investor. A subscription to The Data Driven Investor provides you with solid strategies to analyze the market environment, control portfolio risk, and select the best stocks and ETFs based on quantitative factors. Our portfolios have outperformed the market by a considerable margin over time, and they are built on the basis of solid quantitative research and statistical evidence. Click here to get your free trial now, you have nothing to lose and a lot to win!

Disclosure: I am/we are long ITB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com