Want to buy Home Depot stock? Here is the key number every investor should follow

Some investors are looking to buy The Home Depot (HD 2.80%) stock as a play on the likelihood of a drop in interest rates that would boost the housing market and a corresponding increase in home improvement spending. It’s an intriguing idea, but skeptics suggest the housing market recovery could prove slow, even in a lower interest rate environment.

For anyone following the home improvement retail giant, here’s a key number you should be watching.

Transaction volume, sales growth not comparable

In my opinion, Home Depot will indeed enjoy the benefits of a housing recovery, but it will take time to unfold. The key metric for investors to track is trading volume growth rather than comparable sales growth.

The two are obviously linked, but investors should also consider the effect of average ticket size, not least because inflation-driven price increases have helped offset the decline in trading volumes. The chart of Home Depot comparable sales growth, average ticket price and transaction volume below shows these relationships.

Data source: Home Depot.

A few points to note: First, year-over-year customer transaction growth turned negative in the second quarter of fiscal 2021 due to challenging comparisons to the COVID-19 demand boom in 2020. However, it is important to note that comparable sales growth was positive through the first quarter of fiscal 2023, mainly due to price increases.

Second, when average ticket price growth declined, Home Depot’s comparable sales growth began to decline, consistent with the continued decline in transaction growth.

The main takeaway is the same inflation that drove up home prices also flattened Home Depot’s comparable sales growth at a time when transaction growth was negative.

But here’s the thing: The Federal Reserve will only cut interest rates when inflation is tamed. This means that growth in the overall price level in the economy will be reduced, including the things that Home Depot sells. That means Home Depot might not find it so easy to raise its average ticket price in a recovery. The key metric to watch is an improvement in transaction volume, which will likely translate into comparable sales growth as the recovery develops.

What it means for Home Depot investors

Lower interest rates undoubtedly help the housing market. They lower monthly mortgage payments, create more economic growth and provide a sense of job security that encourages home sales. The existing home sales trend is usually the key number that guides final market conditions for the home improvement sector.

As you can see below, existing home sales began to decline in 2021, just as existing home prices rose, reducing housing affordability. For reference, home affordability refers to the income level of a typical family to qualify for a typical mortgage. Therefore, a higher number means more accessibility and a lower number means less.

Simply put, in 2021, home prices rose, affordability fell, existing home sales fell, and finally (see chart above), Home Depot’s transaction volume began to decline. While it’s easy to blame the Federal Reserve for the housing slowdown, readers should note that interest rates began to rise in the spring of 2022.

Data by YCharts.

Why it might take time for Home Depot’s transaction volume to grow significantly

If the key to the increase in transaction volume is existing home sales, it may be some time before the latter recover significantly. The main reason is that housing affordability remains low. A reduction in interest rates will help with affordability, but as the chart above demonstrates, house prices have recently risen. If they start rising again after an interest rate cut, then affordability still suffers.

Another scenario is that home prices are flat or falling, but it’s unusual to envision falling home prices and an increase in Home Depot transaction volume.

Image source: Getty Images.

Where next for Home Depot?

A recovery in the housing market is likely, but it may be slower than many think. Home Depot is a great way to play in a lower interest environment, but watch its transaction volume increase as a critical indicator of progress. As usual, stocks are best viewed with a long-term mindset, and investors will need to be patient.