The Inventory-Sales Ratio and Homebuilder Return Predictability

The firm’s inventory-sales ratio prices exposure to the housing cycle with a predictable sign. The buyer of a new home holds a pre-construction contract at a guaranteed price with the right to cancel at any date up to delivery. The demand for contracts rises with falling user costs while lot supply is inelastic, leading to land bidding in booms. During busts sales decline and land bidding largely disappears. Delivery is from inventory at a cost of carry below that of construction. The firm’s inventory-sales ratio leads and is negatively correlated with its subsequent returns. For U.S. homebuilders over 1975 to 2009, a 1% increase in the inventory-sales ratio lowers next-quarter returns by five basis points. Copyright Springer Science+Business Media, LLC 2013