Home Depot May Decline In The Future

| About: Home Depot, (HD)

Since the recession ended in 2009, Home Depot (NYSE:HD) has rallied over 150%. This increase in share value has marked a surge in performance which has propelled the security to near all-time highs. Through this article, we will fundamentally and technically analyze this increase in share price and investigate the possibility that Home Depot is due for a downward correction in the near future.

Fundamentally Speaking

In order to study the fundamental landscape of Home Depot, I have relied heavily on return on assets and return on equity. Return on assets is the net income of the firm divided by average assets across an operating period. This key metric allows the investor to determine how efficiently Home Depot is using its assets to generate revenues. Return on equity is similar in that it divides net income by directly-invested shareholder equity. This ratio informs the analyst as to how well the organization is utilizing investments to bring a return to the owners. By studying changes in these metrics, we can quantitatively determine the factors which drive share price and generate forecasts for the future. In the chart below, 10 years of quarterly return on assets and return on equity can be seen for Home Depot.

The chart shows several different economic situations which have confronted Home Depot over the past ten years. In the points and table below, I have shown these different time periods and provided a breakdown of share price performance.

  • Beginning in 2003, return on assets and return on equity increased until the housing market began to decline in 2007. These were very good years for the housing market and the overall economy and Home Depot ultimately benefited as well. Between these 4 years, Home Depot was able to increase its organizational efficiency and managerial effectiveness and the share price responded to these improvements by increasing 60%. The market tends to reward gains in performance and punish fundamental malaise.
  • As the housing crisis began to take hold in 2007, Home Depot suffered. This period of organizational decline lasted until the end of the recession around 2009. During this time period, Home Depot's efficiency and effectiveness, as measured by return on assets and return on equity, was cut in half. The market responded to this fundamental degradation by completely erasing the gains that Home Depot had accumulated during the housing boom in years past. Between 2007 and 2009, shares declined around 43% in value.
  • The end of the recession in 2009 was marked by a surge in fundamental performance. Return on assets and return on equity have increase for the past two and a half years. Over this same time period, the stock has strongly advanced by around 150%.

The table below shows a summary of the previous discussion. Note the lock-step relationship between firm performance and stock performance. The basis of this relationship allows us to objectively analyze Home Depot and generate actionable investing ideas.

As can be seen in the table above, a clear and logical relationship exists between firm performance and stock performance. As an organization improves its asset-based efficiency and betters its equity-based returns, the market tends to reward it with a higher share price. The reason for this relationship is highly intuitive in that investors seek to place capital with organizations that provide strong returns.

In light of this relationship, we should consider the current fundamental developments within Home Depot. For the first time since the Great Recession, Home Depot has experienced negligible fundamental performance. The most recent quarterly results are such that Home Depot almost imperceptibly improved its return on assets and return on equity. This tangibly means that the period of strong growth following the recession has paused and potentially could be ending. As history has shown, changes in firm performance ultimately drive share price. Given the fact that share price has surged over 150% in the past two years, I believe that investors should cautiously consider a short position on Home Depot.

There are two key fundamental issues which I believe dictate the potential decline of this security. The first issue is the return on assets, return on equity, and share price relationship which we have previously discussed. The next issue relates to the nature of the industry in which Home Depot competes. Home Depot derives its income from home improvement activities. Any improvements or declines in the housing market will ultimately affect the company in that it is one of the largest competitors supplying this market. A key metric which measures activity in the housing market is housing starts, provided in the chart below. I have included the share price performance of Home Depot in relation to the housing market below.

It is very important to see that housing starts is intimately related to Home Depot's price performance. It is equally important to note that while the housing market is recovering, it is nowhere near the magnitude of growth experienced between 2003 and 2007. In light of the chart above, investors must surely begin asking why Home Depot has rallied 150% while the housing market has just started to flourish once again. The answer: speculative fervor. There is no fundamental explanation as to why Home Depot has increased nearly 150% over the past two years. This increase is dramatically more than warranted as measured by housing starts, return on assets, and return on equity. Ultimately, I believe that investors are discounting the Federal Reserve's QE3 operation much more than deserved. The Federal Reserve will keep interest rates very low and continue purchasing mortgage-backed-securities until around 2015. This will benefit the housing market through more affordable financing; however I do not believe that we will enter a new era in which the housing market surges to new heights, as implied by Home Depot's share price. Frankly, I believe that Home Depot's 150% surge in share price represents an attractive shorting opportunity based upon irrational investor exuberance.

Technically Speaking

I believe that Home Depot is an exemplary shorting opportunity, but I do not believe that individuals should immediately take the trade. Throughout my experience in the markets, I have found that patience and risk management strongly benefits all market participants and in this section, I will lay a technical framework by which we can logically and intelligently approach this security. Home Depot is in a strong uptrend, however I believe price may break down in the coming months. For this reason, I do not believe that investors should consider shorting until price breaks below $60 per share. This will signal an excellent entry opportunity in that price will have technically violated prior support and additional price declines may occur. I recommend an initial stop-loss at $65 per share to protect investors should price continue increasing. As seen in the chart below, $50 per share represents an area of struggle between the bulls and the bears, and I believe investors would be wise to avoid the battle by exiting half of their shares at this location. The remaining shares should be exited at $45. This location has acted as a ceiling between 2003 and 2007 and I believe that in the future, it may once again possess technical significance. Rather than attempting to guess what will happen at this key figure, I believe that investors should exit their entire remaining position at this location.

The table below shows a breakdown of this trade recommendation. This is a very favorable trade in that the investor stands to gain $2.50 for every $1.00 he or she is willing to risk. Probabilistically speaking, if this analysis even has a 40% chance of being correct, investors would be wise to consider shorting Home Depot.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Tagged: , , , Home Improvement Stores
Problem with this article? Please tell us. Disagree with this article? .