Many investors love housebuilding stocks. But there’s a problem with them. Although they do very well in good times, they suffer horribly in recessions. In the 1990-92 downturn, for example, they lost 40 per cent and in the 2008-09 slump they lost 70 per cent. This poses the question: can we protect ourselves from such losses without foregoing the high returns in good times?
The question gains force from the fact that recessions are unpredictable – or at least haven’t been predicted in the past by professional forecasters. This suggests we can’t rely upon mainstream economic forecasters to get us out in time.
We might, however, be able to use a rule proposed by Meb Faber of Cambria Investment Management. This says we should sell when prices fall below their 10-month (or 200-day) moving average, and buy when they are above it.
To test this rule, I took an equal-weighted basket of five main housebuilders (Barratt Developments, Bellway, Berkeley, Persimmon and Taylor Wimpey) since December 1989. This basket has done very well in this time, rising by an average of 14.2 per cent per year since then. That’s almost 10 percentage points better than the All-Share index has managed, although the gains have come at the price of much higher volatility as well as more cyclical risk.
Note also that this basket has been only lightly correlated with house prices. One reason for this is that housebuilding shares are quick to respond to bad news while house prices tend to be slow and sticky; what happens in housing downturns is that properties take even longer to sell, not that prices slump quickly.
If we’d applied Faber’s rule to this basket since December 1989 – holding cash when it told us to be out of the sector – we would have sacrificed a percentage point of price gains. This is because we’d have missed the early phases of some bouncebacks in prices. But we’d also have avoided some terrible losses. Housebuilders lost over 70 per cent in the 2008-09 recession, but Faber’s rule would have got us out of them in May 2007 and kept us out until early 2009.
| Returns on housebuilders since 1990 | |||
| Buy & hold | 10-month rule | All-Share index | |
| Annual return (%) | 14.2 | 13.3 | 4.5 |
| Standard deviation (%) | 33.4 | 23.8 | 14 |
| Sharpe ratio | 0.43 | 0.56 | 0.32 |
| Maximum annual loss (%) | -75.4 | -34.1 | -36.8 |
| Excludes dividends | |||
By contrast, the worst annual loss under his rule was 34 per cent. This happened last year because housebuilders fell immediately after the EU referendum, triggering a sale which meant we crystallized a loss and missed out on the subsequent bounce.
Overall, a rigid adherence to Faber’s rule would have resulted in a better Sharpe ratio than a buy-and-hold approach. This perhaps understates the benefit of the rule, because it would also have protected us from losses during recessions. And it’s possible that these are especially painful for some of us because they are times when we feel fearful and are losing our jobs and businesses.
What we face here is a trade-off. Faber’s rule ensures that we’ll miss out on some snapbacks in prices. And given the volatility of housing stocks, these can be big. The rule is, in effect, a bet against buying on dips. But it’s benefit is that it protects us from long and deep price falls of the sort we see in recessions.
In effect, the rule costs us pennies but saves us pounds. How worthwhile this is depends upon your general attitude to capitalism. If you think crises of the sort we saw in 2007-09 are once-in-a-generation events which won’t be repeated soon, then you might prefer the buy-and-hold approach – especially because this also gives you some fat dividends. If, on the other hand, you are more fearful of crises, then the rule might be for you.
We might, however, have another protection – foreign currency. The nastiest fall in housebuilding stocks, in 2008, also saw a fall in sterling and hence profits on major foreign currencies. There are good reasons to suspect history might repeat itself. If housebuilders fall because of a global recession, sterling could fall because it is the sort of risky asset which investors dump in bad times. And if they fall because of a local downturn, sterling should fall as investors anticipate lower growth in the UK than elsewhere: this is what happened immediately after the EU referendum.
Foreign currency, though, also has a downside. We might well lose on it in normal times – partly because sterling is cheap in real terms, and perhaps because a relaxation of fiscal policy would strengthen the pound.
We can, therefore, protect ourselves a little from big falls in housebuilding stocks. But the protection isn’t perfect. Insurance always comes at a price.
