The long-awaited homebuilding recovery has yet to materialize, and new headwinds may be building.

#-ad_banner-#This was supposed to be the year that homebuilders could finally celebrate. The rate of new-home construction has been well below average, thanks to still-low levels of new household formation. The Millennial generation has been shacking up with mom and dad — or renting — but many have expected a slowly improving U.S. economy to alter that dynamic. The fact that mortgage interest rates remain near generational lows has been seen as another positive catalyst.

Yet the hoped for rebound still isn’t here. The U.S. Commerce Department recently reported that construction levels were weaker than expected in May. If you’re bullish on the U.S. economy, then you know this sector needs to rumble back to life. Residential construction plays a huge role in the U.S. economy, supporting a wide range of ancillary industries, and a firmer pace of housing construction and sales would make a meaningful dent in our nation’s employment rate. 

Housing needs to get busy. At some point, perhaps sooner rather than later, the benign interest rate environment may vanish, and rising mortgage rates would choke off demand from Millennials. Rising home prices are also denting affordability, according to the Mortgage Bankers Association. Yet affordability may not be the key concern. There may be a cultural shift underway, that leads more toward a renter’s culture than a homeowner’s culture. As a recent article in The Wall Street Journal noted, roughly 65% of American families — owned the homes they lived in during the first quarter of this year, which is the lowest level since 1995 “and is a significant drop from 2006, when a peak of 76.5 million households, or 68.9%, were owner-occupied.”

An increasing number of short sellers think that an upturn in housing will remain elusive. You can see their bearishness by noting the massive spike in short interest in a pair of indirect housing plays. Both Home Depot (NYSE: HD) and Weyerhauser (NYSE: WY) posted big jumps in short interest, in the two weeks ended June 13 (data were released on June 24).

Short Interest (In millions)

Home Depot is a do-it-yourself retailer that sells a range of products that are installed in new homes. Weyerhauser harvests lumber for wood products used in construction.

After reviewing first-quarter results at Weyerhauser, analysts at D.A. Davidson wrote that “Weyerhaeuser management expressed optimism that the housing recovery continues to gain ground… but we maintain a below consensus housing outlook (with a 1.05 million start point estimate) for the year, and note that lumber and panel prices are sharply below year ago levels.”

Short sellers may simply be focusing on the fact that these stocks are fairly richly valued. Weyerhauser, for example, operates in a very cyclical industry. And as a result, it typically garners a fairly low forward price-to-earnings (P/E) multiple. Yet Weyerhauser now trades for 19 times projected 2015 profits.

Home Depot trades for around 16 times projected fiscal 2016 profits. That’s slightly above rival Lowe’s (NYSE: LOW) forward multiple of 15. Yet here’s the unusual thing: While the short interest in Home Depot has surged, Lowe’s short interest actually fell 16% in mid-June, to around 21 million shares.

Both DIY retailers now have similar ratios in terms of a days to cover (five), suggesting that Lowe’s had already been somewhat heavily shorted and Home Depot is now catching up — in a big way.

To be sure, these stocks have already anticipated a sharp recovery in housing. Shares of Home Depot and Lowe’s have surged 250% and 150% respectively over the past five years, well ahead of the broader S&P 500’s 110% gain in that time. 

Risks to Consider: As an upside risk, such heavily shorted stocks may trigger a short squeeze that sends them even higher — if the housing market makes an abrupt upward move later this summer.

Action to Take –> Even if you are not inclined to short these stocks yourself, the huge increase in short interest for Home Depot and Weyerhauser shines a light on the fact that these stocks have already anticipated a housing upturn that has yet to really materialize. Even if new home construction accelerates in coming years, these stocks appear to have already reflected future gains and further upside may be limited.

It is important to distinguish between housing sales and new-home construction. So many homes were bought out of foreclosure in recent years by investors, and many of them will likely look to unload their investments in coming years. As a result, there is likely to be an ample supply of used homes available, blunting the need for new home construction. That could still be good news for firms like Home Depot and Lowe’s, which derive a decent portion of sales from home remodeling. But it would be bad news for Weyerhauser, which has much greater leverage to new home construction.

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