Homebuilder shorts ripe for squeeze as rally gains momentum

and Mortgage rates fall and inflation weakening, short sellers who have been taking advantage of the three-month Treasury note plummet Homebuilder stocks may need to prepare for a rebound to year-to-date highs.

The S&P Composite 1500 Home Construction Index surged more than 20% in a rebound that began in late October and has recouped almost all of its losses from a rout that began in July.

Those gains add to the pain for contrarian traders, who have already incurred $1.4 billion in paper losses against the industry this year, according to S3 Partners LLC.

The increasing value of positions targeting homebuilders also exposes traders to the risk of a short squeeze, which occurs when short sellers are forced to buy back shares to get out of losing positions when a share price rises sharply. The frenzy of short covering has in turn pushed prices even higher.

“With homebuilder stock prices soaring, we should not only expect this short covering trend to continue but also accelerate,” said Ihor Dusaniwsky, managing director of predictive analytics at S3.

Short sellers have bought back $1.3 billion worth of homebuilder shares this year to exit contrarian positions as the sector rallied more than 50% through the end of July. S3 is used to measure the likelihood of a buy coverage event.

Changing population age structure first time home buyers Evercore ISI analyst Stephen Kim said it also helped boost the industry. In the past, first-time buyers were in their 20s, but now the average age of first-time buyers is in their 30s. And those who are older and more mature have the income and credit history to support the purchase.

“The buyer pool is stronger and better able to withstand higher interest rates than they have been in the past,” King said. “This is something the bears did not correctly anticipate.”

So while home prices remain high, limited existing supply, financing incentives from lenders seeking business and a pullback in U.S. 10-year Treasury yields are also supporting the sector’s rebound.

What’s more, builders have also shifted to smaller properties, driving down average sales prices and further eliminating resale premiums, said Bloomberg Intelligence analyst Drew Redding.

Some homebuilders are more vulnerable to the squeeze than others, including KB Home, LGI Homes Inc., Cavco Industries Inc. and Dream Finders Homes Inc., according to S3 data.

To be sure, there are still traders actively shorting as homebuilders rebound. According to S3 data, the market value of shorted stocks in the industry has increased by $926 million in the past 30 days. Meanwhile, short sellers reduced their exposure to short covering by $141 million.

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