Pulte Homes: Rally in a Bear Market or Something More?

| About: PulteGroup, Inc. (PHM)

Much has been written lately about the housing bubble and resulting crash. The papers have a story every day about a home owner or homebuilder who cannot unload what they own or have built. A story last week in the Wall Street Journal titled, “Housing Slowdown Takes its Toll,” indicated in the opening paragraph, “Economists believe cooling in the housing market to extend into next year and many forecasters in the latest WSJ.com survey predict no change – or an outright decline – in home prices next year.” Another on the back of the Boston Herald a few weeks back said something about the “bubble has burst.” These are but a few examples of many relating to the housing markets demise.

What caught my attention with regard to the WSJ article was the forecast that prices would decline into 2007, which is wrong. Prices are declining now! Whether the NAR or the Census Bureau wants to admit this is another story. If you are a condo owner, attempting to sell your place of residence, conditions to sell are extremely trying. If you are unwilling to move the price down 10-20% the home will remain on the market for quite sometime.

Drop your price, throw in an automobile and pay for the closing costs and things get a bit easier. These incentives speak to the power of the buyer. And when there are no buyers, the project is abandoned (as Pulte Homes did a few months ago).

So why would I bother looking at a homebuilder for my next investment idea? Well, that is a good question. On Friday, I posted five questions. One of them was “Have the homebuilders bottomed?” I asked this question because in the charts, several homebuilders have reversed in a very bullish manner on the long term charts. Pulte Homes (NYSE:PHM), for example, had a very bullish candle formation from an oversold position. It has followed this signal with further gains this month. Other homebuilders, such as DH Horton (NYSE:DHI) and Hovnavian (NYSE:HOV), have displayed similar bullish formations.

But can the fundamentals back up these reversal patterns? I am not sure. The local housing market in my area seems to have stabilized just a bit. Though prices were marked down on average 10% in July, homes are selling better versus the beginning of the summer. However, the fundamental supply/demand imbalance continues as more houses come on the market faster than the demand can arrive. This imbalance has slowed a tad over the last few months but not enough to indicate a trend change that can shrink this ratio meaningfully. At this point, the imbalance has put the local market back to 2003 levels. Could it go further? Sure.

Looking at the forecasts for the likes of Pulte, Lennar (NYSE:LEN) and others, the analyst community is using 2003/2004 numbers as its base case for earnings next year. Pulte, which I have been researching for a while now, is forecasted to have new orders and back log levels similar to 2003’s. Interestingly enough, in reading several analyst reports, the average price of the sale is still forecasted higher from the average of 2006.

Given the weakness in the market (and the 10% haircut mentioned previously), how can this be? Further, the gross profit from a home for next year is forecasted to be 17.9% for Pulte (using Susquehanna Financials' numbers). While this number is the lowest since 2001, I think it may actually be too high. The average selling price of a unit, while having an inflation component, should be lower year over year and not higher. This will affect revenue figures for Pulte and for others who are holding the same assumptions. Thus, the market, while thinking these companies have hit rock bottom, perhaps have another wave coming to them.

Now, I am a chartist first and a fundamentalist second. I believe the charts tell the story first and the analysts follow in a few months. Since Pulte has turned up in rather convincing fashion over the last few months, this has got me wondering if this is a rally in a bear market or something more? I think it is a rally in a bear market though I believe highly that this rally is driven by the broad market and not the fundamentals.

In this case, the S&P 500 is moving higher and the Housing Sector Index [HGX] is attempting a comeback of sorts by tagging along on the move. How long does the bounce occur for the homebuilders? I think for the likes of Pulte, you will see the stock continue to rally. Maybe a target of $35 is not out of the question but beyond this level, in my opinion, will be difficult to achieve. Further, I think your risk adjusted return is better in holding the S&P 500 (NYSEARCA:SPY) than holding a homebuilder or the HGX in general. The S&P is growing earnings at a greater clip than its PE while the homebuilders do not have growth and if anything, a risk that earnings continue to languish or move lower.

This is not to say though that I would not buy Pulte. This company is the first to reverse off its lows in the HGX. Beazer (NYSE:BZH) continues to be very weak. Lennar is doing nothing and perhaps DH Horton will break out to the upside this month. But at the moment, Pulte appears to be the only one that I would get excited about and at the moment.

However, there are several issues in owning Pulte. For one, Pulte’s historical PE range is about 8.5-9.5x earnings. Currently it is trading at 10x its 2007 earnings. It is trading at the bottom end of its price to book near 1.2x but given the risk that there could be more write downs this fall, this ratio could be revised up, making the company less cheap. Lastly, it has had earnings growth every year since 1998. Given the premium companies get from earnings growth these days, I have to believe this is a major negative.

So what does one do when the fundamentals and the technicals collide? Being a technician, I do the following. I ride Pulte higher with a stop below the lows near $28. I look for the $35 level and say goodbye or at least cut back the position. Normally when I buy a stock, it must be trading cheap to growth and closer to its historical book. Further, it must have a positive chart and an upward trend line.

In Pulte’s case, only the book value argument holds. The technical chart pattern is a reversal of sorts but I do not think that beyond $35 is the place that PHM will visit. Interestingly enough, at that point, the trend will either turn up or be rejected. I am betting on the latter.

PHM 1-yr chart:

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