Homebuilder shorts are ripe for a squeeze with rally gaining strength

With mortgage rates retreating and inflation abating, short sellers who'd been capitalizing on the three-month slump in homebuilder stocks may need to prepare for a rebound toward year-to-date highs.

The S&P Composite 1500 Homebuilding Index has surged more than 20% in a bounce-back rally that started at the end of October and regained nearly all losses from the rout that began in July. 

Those gains set up contrarian traders for more pain, adding to the $1.4 billion in paper losses they've already put up betting against the sector this year, according to data from S3 Partners LLC. 

The growing value of positions against homebuilders also puts traders at risk for a short squeeze, which happens when stock prices rally so much that short sellers are forced to buy back shares to unload those losing positions. That frenzy of short covering, in turn, pushes prices even higher. 

"With homebuilder stock prices spiking we should not only expect this short covering trend to continue but for it to accelerate," said Ihor Dusaniwsky, managing director of predictive analytics at S3.

Short sellers have already bought back $1.3 billion of homebuilder stocks this year to exit contrarian positions as the sector gained more than 50% through the end of July. The threat of a short squeeze has nearly doubled for homebuilders in the last month, according to a measure S3 uses to gauge the potential for a buy-to-cover event.

A shift in age demographics for first-time home buyers has also helped lift the sector, Evercore ISI analyst Stephen Kim said. In the past, first-time buyers were in their late 20s, but now the average first-time buyer is in their late 30s. And those older, more established buyers have the income and credit histories to support a purchase.

"The buyer pool is stronger and better able to withstand higher rates than buyers in the past," said Kim. "That was something that the bears did not anticipate correctly."

So while home prices remain elevated, limited existing supply, financing incentives from lenders seeking business and a pullback in the US 10-year Treasury yield are also supporting the sector's bounce.

What's more, builders have also shifted to smaller square footage properties, resulting in lower average selling prices and further eliminating the premium over resales, Bloomberg Intelligence analyst Drew Reading said. 

Some homebuilders are more primed for a squeeze than others, including KB Home, LGI Homes Inc., Cavco Industries Inc. and Dream Finders Homes Inc. according to S3. 

To be sure, there are still traders actively betting against homebuilders as they rebound. In the last 30 days, the market value of shares shorted in the sector rose by $926 million, according to S3 data. At the same time, short sellers reduced exposure with $141 million of short covering.