🔑 Single Family Rental Surge

Happy Sunday to everyone on The Street.

I love Zillow. I scroll through the app way more than Instagram, Twitter, and definitely Facebook. This is partially why I found their "Bold Predictions for 2023" fascinating and worth sharing in case you missed it.

In a nutshell, Zillow thinks Midwestern markets will heat up, more friends and family members will pool their money to buy homes together, and we'll see a surge in first-time landlords.

The online real estate platform also thinks the affordability crisis will stabilize, if not improve. This is good news for both buyers and renters.

For buyers, Zillow is "seeing some recent and encouraging progress downwards" on mortgage rates. While the volatility could continue through the early part of next year, "the Federal Reserve may ease its aggressive monetary contraction" which could hopefully help rates settle at a more digestible level.

For renters, they noted that "rents actually fell during the month of October, the first time in two years, a signal of a return to regular seasonal patterns." They cited additional inventory coming online as well.

Let’s see how these predictions hold during what promises to be another interesting year for the US real estate market. We're starting today's newsletter with one of Goldman's top real estate stocks, scroll down to see why they like it.

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Review

US stocks were mixed Friday, but ultimately ended the week lower as investors reacted to the latest economic data.

The Producer Price Index rose 0.3% month-over-month in November, exceeding expectations. This figure shows that wholesale prices remain elevated and that inflation is still not under control.

As a result, analysts turned their attention to this week’s consumer price print and Federal Reserve rate-hike decision. Most are expecting a 50-basis-point increase, after four straight hikes of 75-basis-points.

Many Wall Street veterans feel the Fed’s most aggressive rate hikes are in the past, despite the elevated PPI. However, with a relatively strong job market and hotter-than-desired inflation report, traders are looking for more context from the central bank as it relates to their outlook for 2023.

Elsewhere, oil prices rose after coming under pressure recently due to concerns that slower economic growth will curb demand for energy. Overseas, major stock indexes gained in China, as property stocks led the way.

In company-specific news, Lululemon saw its share price plummet after issuing a weaker-than-expected fourth-quarter forecast. On the flipside, Bath & Body Works gained after activist investor Dan Loeb announced he had increased his stake in the retailer.

Meanwhile, Chinese tech giant Huawei is licensing its treasure trove of 5G patents in hopes of bringing in fresh revenue. This decision comes after the US issued sanctions that hurt its smartphone business.

For the week as a whole, the Dow fell 2.77%. The S&P tumbled 3.37%, while the Nasdaq dropped 3.99%. It was the Dow's worst week since September.

Preview

Tomorrow, the US monthly budget statement for November will be released. The deficit sat at $88 billion in October, well below the $165 billion deficit from the same period last year. This report will also offer insight into individual and corporate taxes, defense spending, and payment on interest for Treasury debt securities.

Tuesday, the market will be closely watching as the latest inflation print is due. The November CPI will show whether the Federal Reserve’s rate-hike campaign is slowing inflation, as intended. The CPI rose 0.4% month-over-month in October, although the inflation rate slowed to 7.7% on an annual basis, coming in below forecasts.

The Fed will dominate focus on Wednesday, as the central bank will announce its next decision in regards to interest rates. The general consensus going into the meeting is that a 50-basis-point hike will be enacted, following four straight 75-basis-point hikes. This will impact interest rates on everything from mortgages to credit cards.

On Thursday, the market will gain insight into the state of consumer spending with the November US retail sales report. Sales surged 1.3% month-over-month in October after coming in flat for September. Other reports set for release include last week’s jobless claims, as well as industrial production and business inventories for November.

On Friday, watch for the S&P Global (SPGI) December Purchasing Managers’ Indexes for manufacturing and services.

Earnings

Monday, Oracle (ORCL) will present its third-quarter earnings. The software company will likely give insight into the massive cloud-computing contract it co-signed with the Pentagon. The veteran software company will join forces with Amazon (AMZN), Google (GOOGL), and Microsoft (MSFT) to build infrastructure technology for the US Department of Defense. The contract could grow to $9 billion by 2028.

Tuesday, Photronics (PLAB), the third-largest semiconductor photomask supplier, will speak on its third-quarter progress. Investors will be tuning in to hear more about the company’s prospects and the semiconductor industry as a whole.

On Wednesday, homebuilding company Lennar (LEN) will release its third-quarter results. Investors will be looking for more clarity as to the state of the housing market.

On Thursday, Adobe (ADBE) will report earnings. In addition to information about its business, Adobe could offer insight into the Adobe Digital Price Index. This measure of online inflation just reported its largest year-over-year drop in the past 31 months.

On Friday, Accenture (ACN), Olive Garden owner Darden Restaurants (DRI), and Winnebago (WGO) is all set to share their latest results. Accenture executives may be asked to discuss the recently-launched Velocity, a service developed in tandem with Amazon Web Services that aims to optimize business outcomes.

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Goldman's Real Estate Pick

Supply-Demand Imbalance

Okay so Zillow thinks it's the Midwest's time to shine and affordability may stabilize. But what about specific products within the real estate industry? What do people want that we don't have enough of? As with any business, most of the time opportunity boils down to supply and demand mismatches. According to Goldman Sachs, there's an imbalance in one specific segment: single-family home rentals.

Thanks to inflation and supply chain snags, homebuilders have slowed construction, thus limiting supply. Meanwhile, sky-high mortgage rates have deterred potential homebuyers. This is pushing them back into the rental pool, which is then creating more demand.

"Homeownership Continues to be Very Expensive"

As a result, the investment bank has identified one company that is well-positioned to capitalize on this trend. Analyst Chandni Luthra recently upgraded real-estate investment trust American Homes 4 Rent from neutral to buy, slapping a $39 price target on the stock. On Friday the stock closed at $32.86.

In a note to clients last week, Luthra said “We remain constructive on the strong demand for housing amidst a shortage crisis, and single-family rental (SFR) is well positioned as homeownership continues to be very expensive, boding well for the long-term fundamental." Even though rental prices are falling, American Homes 4 Rent should be able to keep them above pre-COVID levels according to Luthra.

Be Selective

Over the past four years, American Homes 4 Rent has increased its number of new homes to roughly 2,150. This figure hovered around 600 in 2018. The newly constructed homes have been cheaper to maintain, which helps keep costs down.

There are other players in the single-family home rental space, including Invitation Homes (INVH) and Tricon Residential (TCN). With that said, Luthra doesn't like them as much. High leverage and interest rates has slowed Tricon and they haven't been growing as quickly without acquisitions. Meanwhile, Invitation Homes has been battling ongoing litigation, high property taxes, and debt issues.

Again, no one has a crystal ball for 2023, especially as it relates to the real estate sector. But with mortgage rates still relatively high and construction not at a pace where we need it, single family home rentals might be in interesting space to watch.

Biotech Stocks Still Have Life Left in Them

Large and Mid-Cap Biotechs to Play in 2023

Biotech stocks have fallen off their perch this year amid rising interest rates and fears the economy is heading into a recession. Despite those concerns, Morgan Stanley sees opportunities amid the rubble. It's not just large-cap biotech stocks that have the cash flow to weather an economic downturn but also select small and mid-sized ones that should provide investors with an opportunity to make money.

“We expect potential M&A to be a supportive backdrop with innovation and new drug launches offering a strong outlook for mid-cap growth names,” Morgan Stanley analyst Matthew Harrison wrote in a research report this week. “Large caps remain attractive with defensive cash flows, but we expect risk appetite to return for selective SMIDs.”

Innovation, M&A Driving Upside

The way Morgan Stanley sees it, innovation in the biotech market with things like gene and cell therapy should provide an upside for the industry during 2023. Also helping the group, according to Harrison is a “stabilizing” interest rate environment, cooperative FDA, and a pick up in M&A. Mid-cap biotech stocks “are at an inflection with both significant revenue growth and a potential turn to profitability,” Harrison wrote. Among Harrison’s picks are BeiGene (BGNE), Regeneron (REGN), Biogen (BIIB) on the large-cap front, and BioMarin (BMRN) for the small and mid-cap play.

In the case of BeiGene, the China-based biotech focused on cancer treatments, Morgan Stanley thinks 2023 will be a “transformative year” so much so that the stock could more than double. The analyst pointed to its Brukinsa cancer drug for leukemia as one of the big growth drivers for BeiGene.

BioMarin is a Small Cap Top Pick

Meanwhile, Harrison thinks Regeneron stock could gain 14% from its current price and Biogen shares could appreciate 7.7%. That's on top of double-digit gains so far in 2022. The analyst is betting Biogen’s Alzheimer’s drug will be the drug of choice when competing against Eli Lilly’s (LLY) offering.

Among small and mid-cap stocks, BioMarin is Morgan Stanley’s top pick thanks to its gene therapy to treat a type of hemophilia.“We expect 2023 to finally be the year that commercial upside can drive BMRN higher,” Harrison wrote in the report.

The economy is slowing and interest rates are rising, but that shouldn’t stop biotechs from innovating and deal-making as we head into 2023.

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Small Cap Stocks Are On Sale

Small Caps Poised to Outperform Bigger Rivals

The small-cap effect in which small companies produce greater returns than their larger counterparts may no longer be the case, but for investors looking for bargains, small-cap stocks could be a place to find returns.

At first glance, small-cap stocks don’t appear that cheap. The Russell 2000 is close to trading at 20 times earnings, which is slightly higher than its long-term average. If you take out the small-cap stocks that are not profitable, however, the price-to-earnings ratio for the group declines to 12 times earnings. That’s lower than the long-term average of 15 times earnings.

Bank of America analyst Jill Carey Hall thinks small-cap stocks are trading at a 30% discount to their larger brethren. That is the biggest discount since the dotcom boom in the late 1990s. Even the potential for a recession shouldn’t deter the group. Hall thinks a recession on par with the financial meltdown of 2008 and 2009 is already baked into the stocks.

Western Boots and Oil Drilling

For investors seeking recession-proof investments, small caps should help. They outperformed the broader market in the 1970s and 1980s when inflation was high and the economy was in a slowdown. Some investors think they should do the same this time around.

So which stocks do small-cap bulls think are worth considering? It runs the gambit from Boot Barn Holdings (BOOT) which makes boots and Western apparel to Magnolia Oil & Gas (MGY), the oil and gas driller.

Take Boot Barn for starters. Small-cap bulls like the stock because it has fixed costs that are low and is a leader in the market for Western boots and clothing. Magnolia Oil & Gas is attractive because it generates cash and has no debt. Other small-cap stocks analysts that have their eye on include Stelco (STLC), the Canadian steel maker which is sitting on more cash than debt, and Tapestry (TPR), which makes high-end handbags including Coach and Kate Spade. It pays a dividend and is wooing younger shoppers, which should drive future growth.

Other small caps with the potential to appreciate in the coming years are HubSpot (HUBS), Ceridian HCM (CDAY), SiteOne Landscape Supply (SITE), and Saia (SAIA). All of the stocks are down in many cases by double digits.

Did Anyone Say Low-Cost ETF?

For investors who want more broad exposure to small-cap stocks there are several low cost funds to choose from. The iShares Russell 2000 (IWM) is a way to get exposure to that index while the SPDR S&P 600 Small Cap ETF (SLY) gives you exposure to another small cap index, one that has outperformed the Russell 2000 by over a percentage point in the past five, 10 and 20 years. It also tends to be less volatile.

The small-cap effect may appear dead but bargain-hunting investors can’t deny they are cheap. With many of the stocks down double digits and with small caps in a better position to weather the recession than some of their larger counterparts this may be the opportune time to get exposure to the little, scrappier players in the market.

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