Morgan Stanley says housing recovery still in 'middle innings,' upgrades Home Depot to overweight

Published Thu, Feb 23 201710:44 AM EST

The recovery in the housing market has more room to run and investors could capitalize on this trend by buying shares of Home Depot , according to analysts at Morgan Stanley, who upgraded the home improvement retailer to overweight from equal weight on Thursday. "The data suggests the housing recovery is in the middle innings, not the 8th/9th which the market believes," equity analyst Simeon Gutman wrote in a research note. Analysis by the investment bank shows that 44 of the top 75 core urban areas in the United States — where 60 percent of the U.S. population live — have yet to see home prices recover to the pre-financial crisis levels during 2006-2008. "The breadth and depth of this statistic suggests there is potential for nonrecovered/recovering housing markets to reach their prior peaks and continue growing thereafter," Gutman said. Despite investor concerns about the potential effects of higher interest rates on mortgage applications, Morgan Stanley says this cycle appears "less problematic" because they are unlikely to shoot higher overnight. "This cycle seems [gentler] than prior ones in terms of absolute level of rates and the speed at which they are moving higher," Gutman wrote. The analyst notes that even during the most aggressive cycles of interest rate hikes, it often takes about eight quarters for the housing market to absorb those changes, while incremental increases have a minimal effect on mortgage payments. "For context, a 25 bps increase in mortgage rates on a $200,000 house will increase one's monthly mortgage payment $40, a seemingly insignificant amount," according to Morgan Stanley. Analysis by the investment firm also shows that shares of Home Depot have fared better than investors might expect during periods of rising rates, with the stock outperforming in four of the past six tightening cycles. "HD and LOW have outperformed the S & P in rising rate environments, on average. This time should be no different as we see home pricing gains despite increasing mortgage rates given favorable supply & demand economics," Gutman said. Apart from the opportunity for home prices to rise on increasing demand, Morgan Stanley says consumers are well-equipped to withstand higher rates because of improvements in households' balance sheets. On the consumers' balance sheet, Morgan Stanley writes: "The US household balance sheet is in sound shape and consumers can withstand future interest rates increase or a softening in the economy. Since peaking at 1.35 ahead of the financial crisis, the ratio of household debt to disposable income has declined nearly 30% and is now at levels last seen in 2002. At the same time, net worth has recovered to pre-recession highs relative to disposable income. At the same time, net worth has recovered to pre-recession highs relative to disposable income." In the next 12 months, Gutman predicts shares of Home Depot could trade as high as $165, implying a gain of nearly 14 percent from Wednesday's close. Given the strong fundamentals in the housing sector, the analyst also reiterated an overweight rating on Lowe's with a 12-month price target of $88, implying a gain of about 15 percent from here. Year to date, shares of Home Depot and Lowe's are each up 8 percent compared with a gain of 5.5 percent for the S & P 500.

People purchasing plywood at Home Depot in Miami, Florida.

Gaston de Cardenas | AFP | Getty Images

"The data suggests the housing recovery is in the middle innings, not the 8th/9th which the market believes," equity analyst Simeon Gutman wrote in a research note.

Analysis by the investment bank shows that 44 of the top 75 core urban areas in the United States — where 60 percent of the U.S. population live — have yet to see home prices recover to the pre-financial crisis levels during 2006-2008.

"The breadth and depth of this statistic suggests there is potential for nonrecovered/recovering housing markets to reach their prior peaks and continue growing thereafter," Gutman said.