Nailing Profits With NAIL If Interest Rates Stabilize Or Decline (NYSEARCA:NAIL)

The Dow Jones U.S. Select Home Construction Index plunged in early 2020 as the global pandemic gripped markets across all asset classes.

After rising to a record 8,947.33 high in February 2020, the index plunged 49.5% to a 4,520.63 low on March 20, 2020. The tidal wave of central bank liquidity driving short-term U.S. interest rates to zero percent and a tsunami of government stimulus programs caused the index to explode 228.3% higher to a 14,839.16 peak in late 2021 as thirty-year conventional fixed-rate mortgage rates sat below the 3% level.

However, the market for new construction cooled as the Fed realized rising inflation was a structural issue and not the result of pandemic-inspired supply chain factors. Rising prices caused the Fed to increase interest rates in March 2020, and the index fell 40.8% to a higher 8,784 low in June 2022.

Since June 2022, the index has taken off on the upside, reaching a new record peak in June 2023, even though rates continued to climb. The stock market has been fighting the Fed over the past months, and the Home Construction Index ignored increasing rates, making higher highs over the past months.

The Direxion Homebuilders & Suppliers 3X ETF product (NYSEARCA:NAIL) has been nailing profits since the Home Construction Index made another higher low in October 2022. NAIL is a leveraged ETF product that increases profit potential, but the cost in a far higher risk level than non-leveraged instruments. NAIL employs options and swaps to create leverage. The cost is time decay, as products like NAIL offer turbocharged returns when the underlying assets move in the anticipated direction. However, when they remain stable or decline or move in a contrary direction, NAIL and other leveraged products can quickly lose value.

Rising interest rates have been bad news for home borrowers

In late 2021, a conventional 30-year fixed-rate mortgage was below 3%. In January 2021, the rate fell to a record 2.65% low. The rising Fed Funds rate, quantitative tightening to reduce the central bank’s swollen balance sheet, and inflation well above the Fed’s 2% target level pushed the mortgage rates over 7% in September 2023. Since the end of 2021, rising interest rates caused the monthly payment on a conventional $400,000 mortgage to rise more than $1,300, excluding many potential buyers from the market. Moreover, given the explosive move in mortgage rates, homeowners who refinanced or purchased homes over the past years with 3% or lower mortgages have no incentive to sell their properties and move.

Therefore, the supply of existing homes for sale has declined. The situation could not be worse for buyers looking to purchase their first home. Existing home supplies have dropped, keeping prices high, while new home mortgage rates are at the highest levels in years. Meanwhile, new home sales rose in July 2023, beating estimates and rising to a 17-month high as buyers had to turn to new construction, given the historically low supply of existing homes.

The pandemic buying spree ended – New home construction suffered but came roaring back

While the 2020 pandemic caused many financial problems, it ignited a furious rally in the housing market. Money was free, with mortgage rates under 3%, and buyers watched as home prices soared each month. Moreover, working from home presented new opportunities as commuting was no longer an obstacle for many buyers. States with no or low income tax experienced migration and a new home construction boom. Florida, Texas, Nevada, and other states attracted migration from New York, California, Illinois, and other high-income tax states.

As interest rates began rising in 2022 and throughout 2023, the demand for housing cooled. However, prices remain high, and the low level of existing properties for sale has encouraged home building. Shares of home construction companies soared from the 2020 pandemic-inspired low.

The iShares U.S. Home Construction ETF product (ITB) chart shows the explosive 273% rally from $22.39 in March 2020 to $83.43 in December 2021 as mortgage rates remained below the 3% level. ITB owns shares in the leading U.S. home building and related supply companies.

While ITB corrected 42.4% to a $48.02 low in June 2022 as mortgage rates climbed, higher prices from June 2022 through September 2023 did not stop ITB from recovering and reaching a new and higher high at $89.69 in July 2023. ITB remains near the record peak at over $85 per share on September 7. The bottom line is the low existing home supplies have been more significant than the highest mortgage rates in two decades, since 2002.

The Fed remains vigilant- The 2% inflation target could prove elusive

The U.S. central bank has been vigilant in its monetary policy approach as inflation remains at the highest level in decades. While consumer and producer prices decreased, the core CPI and PPI data show more than double the 2% target inflation rate.

The annual Jackson Hole, Wyoming, Fed gathering statements continued the commitment to maintain restrictive monetary policy. While monetary policy can impact the economy’s demand side, which plays a role in reducing prices, supply-side factors can be another story. Over the past weeks, energy prices have been moving higher. Core CPI and PPI exclude volatile food and energy prices but can impact other costs as energy is a critical input in all goods and services. Therefore, the rise in crude oil and oil product prices since the early May lows will likely filter through the economy, stabilizing inflationary pressures at an elevated level. Similarly, rate hikes since March 2022 have a lagged economic impact, which could keep inflation under control.

The bottom line is the hawkish monetary policy may not be enough to reduce inflation as geopolitical factors are above the Fed’s pay grade. The 2% target is arbitrary, but the U.S. and other central banks agree it is the optimal inflation level. However, the ongoing war in Ukraine and the deterioration of relations between the U.S. and China/Russia have supply-side ramifications that could make the target unrealistic in the current environment.

Even if the central bank continues to increase rates, the hawkish rhetoric will likely exceed the action as the market will only tolerate one or two more Fed Funds Rate hikes, which could push the short-term rate near the 6% level. However,

A sign the markets are digesting higher rates is the stock market rally

The two most compelling signs the market is digesting higher interest rates come from the housing and stock markets. The rise in the ITB ETF is a sign that new housing demand remains robust despite an over 7% level in mortgage rates. The other factor that tells us the market has digested the rate hikes is the price action in the overall stock market since the end of 2022.

The S&P 500 chart, the most diversified U.S. stock market index, highlights the nearly 16% rise from 3,839.50 on December 30, 2022, to 4,450 on September 7. Falling bonds and rising interest rates are supposed to be bearish for stocks as they attract capital away from equity and into fixed-income assets. However, rising rates have not stopped the bullish trend in stocks or housing demand.

Stable to lower rates could cause a wave of home buying- NAIL is a short-term leveraged ETF that follows the Dow Jones U.S. Select Home Construction Index.

The Fed Funds Rate rose 5.375% from March 2022 through September 2023. Mortgage rates moved over 4% higher since the end of 2021. The bottom line is the trajectory of interest rate increases will, at worst, slow, likely stabilize, and, at best, begin to ease lower over the coming year. The pent-up demand for housing, rising rents, and low existing home supplies could cause another housing boom, increasing prices and fostering new construction in 2024. A stable or lower mortgage rate environment could have explosive results.

The fund summary for the Direxion Daily Homebuilders & Supplies Bull 3X ETF (NAIL) states:

The top holdings as of September 5, 2023, include:

At $71.04 per share, NAIL had around $229 million in assets under management. NAIL trades an average of over 250,000 shares daily and charges a 0.98% management fee. NAIL pays a minimal $0.16 blended dividend, translating to a 0.23% yield.

ITB rose 86.8% from the June 2022 $48.02 low to the $89.69 July 2023 high. The Dow Jones U.S. Select Home Construction Index rose 81.8% from 8,784 to 15,969.07 over the same period.

Over the same period, NAIL rose 358% from $18.98 to $86.91 per share. NAIL is a leveraged product that suffers from time decay. Therefore, if the housing sector stabilizes or moves lower, NAIL will lose value. However, another leg upward in the housing sector will create turbocharged returns for NAIL investors and traders. Price and time stops are critical to control elevated risks when trading or investing in leveraged products.

As the housing market is heading into the 2023/2024 winter, the upward trajectory may slow, and NAIL could experience a significant decline. I favor monitoring NAIL over the coming weeks and months. A downdraft could create a golden buying opportunity for 2024 if the tight housing sector experiences another leg higher as rates stabilize next year. NAIL could be a product that nails some attractive gains in 2024 if the bull market in home prices and new construction continues.