One common misconception about bull and bear markets is that all stocks top or bottom with the broader market. The reality is that there tend to be tons of diffusion at these inflection points and often we will see stocks with strong fundamentals diverge from the general market trend.

Some recent examples include many speculative growth and tech stocks topping out in early 2021 while the broader market didn't top until January 2022. Earlier this year, many commodities, industrials, and agricultural stocks were making new highs even as the market was venturing into the bear market territory.

Another interesting development happening in financial markets is that homebuilder stocks seemingly bottomed in May of this year. Then, the sector traded sideways for a couple of months before starting to rally as inflation expectations peaked and have begun to move lower. Interestingly, there was a notable divergence as homebuilder stocks made a higher low, while long-term rates made a higher high a couple of months ago.

This is even more interesting considering that the fundamentals for the homebuilders have continued to deteriorate in terms of data based on measures like the NAHB which show that homebuyer traffic remains very weak. Homebuilders continue to post strong results as they work through backlogs, but future growth is dependent on lower mortgage rates.

In some sense, homebuilders are in a similar situation to many other stocks, since it is so sensitive to mortgage rates. One potential outcome for 2023 that many analysts are predicting is that the US tumbles into a recession which would compel the Fed to cut by the end of the year. This scenario would be challenging for homebuilders because the tailwind of lower rates would be offset by demand dropping due to a recession. Yet, this exact scenario has played out in the last couple of months as growth has slowed, rates have moved lower, and the homebuilders have put together nice gains.

Looking across the sector, most homebuilders are about 20 to 30% higher from their May lows. For next year, most are seeing declines in earnings of about 15 to 25%. But, this does seem to be priced in as forward P/E multiples are in the high single-digits or low double-digits. Many could also benefit from reduced inflationary pressures in terms of higher margins.

Overall, homebuilders look like a great option for anyone who is feeling confident about the 'soft landing' scenario as they would benefit from lower rates and inflation while seeing demand remain strong. Under different scenarios of weakening growth or stubbornly high rates, the risk/reward becomes much less attractive.