After last week’s hot inflation report, irrationality has once again returned to the stock market. When investors are scared, they tend to follow the herd instead of thinking for themselves.

For proof, consider this recent CNN headline: 5 Signs the Housing Market is Starting to Slow Down. Long story short, rising mortgage rates have made homes more expensive, thereby suppressing demand.

That makes sense. What doesn’t make sense is the stock market’s reaction to that trend.

During the six days leading up to and including last week’s CPI report, the SPDR S&P Homebuilders ETF (XHB) gained 1.6%. At the same time, the Apartment Income REIT Corp. (NYSE: AIRC) lost 1.9%.

That doesn’t make sense. Homebuilders could be in for a lot of pain this year if interest rates remain high.

That’s because apartment dwellers that might otherwise buy a home may decide to stay put. Why buy a house now when it might be 10% cheaper six months from now?

According to ApartmentList.com, “Over the first half of 2022, rents have increased by a total of 5.4 percent, compared to an increase of 8.8 percent over the same months in 2021. Year-year-over growth currently stands at a staggering 14.1 percent, but has been trending down from a peak of 17.8 percent at the start of the year.”

The deceleration in both of those metrics was most likely due to the red hot real estate sales market during the first five months of this year. Apartment renters were buying homes to take advantage of artificially low mortgage rates.

All that changed in June when the Fed raised the bank overnight rate by 75 basis points. Mortgage rates shot up and sent potential home buyers scurrying back into their apartments.

Playing Both Sides of the Fence

I don’t put much faith in anecdotal evidence. But in this case, it is too compelling to ignore. I know a lot of people in the real estate development business and all of them are telling me that business has come to a screeching halt.

I also have a daughter searching for a home to rent to accommodate her new puppy. She was able to sublet her studio apartment immediately since the rent she committed to five months ago is now 10% below the current market rate.

I believe the July numbers for real estate sales and apartment rentals will make clear just how much the market has changed. New home sales are plunging while demand for apartment rentals is surging.

If I’m right about that, then there are two ways for stock market investors to profit: sell short the homebuilder industry and buy long the apartment rental sector. Both of those strategies can be implemented by using stock options.

In the first case, buying a put option on XHB is an easy way to participate in a decline in homebuilder stocks (put options increase in value when the price of the underlying security goes down). Its top holdings include Lennar (NYSE: LEN), NVR (NYSE: NVR), and D.R. Horton (NYSE: DHI).

Last week while XHB was trading near $59, the put option that expires on December 16 at the $59 strike price could be bought for $5. For this trade to be profitable, XHB must fall below $54 within the next five months.

In the second case, buying a call option on AIRC would allow you to profit from rising apartment rents (call options increase in value when the price of the underlying security goes up). The company owns multifamily housing properties in the largest markets in the United States.

Last week while AIRC was trading near $42, the call option that expires on November 18 at the $40 strike price could be bought for $5. For that trade to be profitable, AIRC must rise above $45 within the next four months.

Either Way, I Win

In this case, I am tempted to put on both of those trades at the same time. I just don’t see how new home sales will go up anytime soon. At the same time, the Rental Vacancy Rate in the United States is near its all-time low which means supply is very limited.

If the Fed’s aggressive rate hikes cause a recession, then new home sales will fall even faster. That may also cause rental rates to level off, but demand for apartments should not be adversely affected.

And if the Fed is successful in slowing down inflation without causing a recession, that does not mean that mortgage rates will go lower. It only means that they will not rise much higher.

Either way, I win as long as my outlook for the real estate market proves accurate. That’s the type of investment strategy that appeals to my opportunistic approach to risk and reward.

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