Did you get the memo to buy the most unloved area of the market?
Of course you didn’t!
Chances are you’re inundated with AI this or that… or meme-stock mania… and missed it.
I don’t blame you. The mainstream media often focuses on the here-and-now instead of what’s more important… what’s coming next.
While we can never know for sure what lies ahead for the market, data undoubtedly helps remove the clouds of uncertainty… and enlightens us to big potential opportunities hiding in plain sight.
That brings us to today…
Over the past two years, the real estate sector has suffered mightily while most other stocks thrived. A swift increase in interest rates was no match for the rate-sensitive sector.
But one fundamental signal is pointing to surprising potential gains…
Before we jump into it, let’s review the biggest pain point for the market the last few years.
The End of Real Estate’s “Dead Money” Era
There’s a reason you never hear about real estate stocks in the financial media. The area has been dead money for years.
Check out this chart, which shows the performance of all major market sectors since the start of 2022:
The real estate sector has shed a quarter of its value since January 2022.
Contrast that to the biggest outperforming group: energy. High inflation created a tailwind for oil & gas names. The group has been far and away the big winning area at 69%.
So why have real estate stocks suffered so much?
Capital-intensive businesses like real estate investment trusts (REITs) get penalized when interest rates surge. The cost to service debt increases… and servicing debt is a REIT’s entire business. They borrow money to buy properties and earn income on them. The higher the cost of that debt, the lower their profits.
Not only that, but real estate is really an income play. Yield-hungry investors choose them for their reliable income stream more than for their hard assets.
Revisiting Econ 101, we know there’s an inverse relationship with REITs and interest rates. When rates rise, investors can view safer treasuries as a better income alternative… especially when rates shoot up in a short period of time.
Notice how the Real Estate sector (blue line) falls when the 10-year Treasury yield pops (yellow line). Lately yields have come down as investors are betting that the Federal Reserve will finally start cutting rates.
That’s helped REITs rally the last couple of weeks:
Source: FactSet
And this latest lift for the beaten-down group is likely the start of a meaningful upward advance.
Why a Powerful REIT Rally Could Soon Begin
Over a month ago, we studied how REITs often outperform in Q2. While we are sandwiched in the middle of the quarter, the jury is out on whether history will prove to be correct.
But signs are pointing towards big gains on the way. As a reminder, we also studied a reliable seasonal pattern that shows how REITs tend to be one of the best performing sectors from late May through July since 2010.
Of course late May isn’t here yet, so we can’t study 2024’s performance. But looking at May’s return for real estate stocks, it’s putting in a stunner. The group is up 7.36% month-to-date, only behind Utilities’ 7.41% gain and Technology’s 10.31% haul.
So, why am I so confident on this latest up move for the most-hated group in years?
It comes down to one word: Valuation.
One of my favorite valuation metrics is the price-to-earnings (P/E) ratio. This shows you how much you’re paying for an asset relative to the earnings it produces. The lower the reading, the cheaper the asset.
Currently the S&P 500 Real Estate sector trades at a 16.74 forward P/E. That actually falls in the lower tier of P/Es.
The following 20-year chart shows this beautifully.
On the top panel is the S&P 500 Real Estate sector. Below it is the weekly forward P/E, which ranges from 9.67 at the depths of 2008 to the peak of 24.68 at the prior market-cycle peak of late 2021:
Source: FactSet
What’s important about today’s valuation level is that anytime the group trades below 17, it has represented value… and a powerful buy signal.
So before you write off real estate stocks, consider the following study.
Since May 2004, whenever the Real Estate sector traded at a forward P/E of 17 or less:
- Three months later, the sector jumped 6.4%
- Six months after, the average gain ramped to 11.9%
- In 12 months, you’re staring at 24.3% gains
- If you’ve got 24 months to hold, the average rally stood at 52.4%
Don’t be afraid to start dipping your toes into the REIT dead zone. Interest rates are set to fall sooner than most people realize.
And once we’ve seen multiple rate cuts, this unloved group should be well into recovery.
Regards,
Lucas Downey
Contributing Editor, TradeSmith Daily
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Source: TradeSmith