In the wake of a 75% collapse in aggregate activity from 2006 through 2008, and an ensuing four-year pattern of housing starts stagnation at historically low levels, little has changed. There remains no chance of a near-term, sustainable turnaround in the housing construction market, unless there is a fundamental upturn in consumer and banking-liquidity conditions. That has not happened and still does not appear to be in the offing. - John Williams, Shadowstats.com
I have written several articles which explain why the true fundamentals of the housing market show that, after a bounce in home sales on account of a massive amount of the stimulus injected into the housing market by the Fed and the Government, the brief recovery is coming to an end and the bear market that started over five years ago is reasserting itself. Data on new home sales for August released today and by KB Homes (KBH) yesterday reinforce my thesis. On the basis of the latter, I used yesterday's spike up in the homebuilder stocks established a short position in KBH stock to go along with my short position in DR Horton (DHI).
The Census Bureau released new home sales for August (pdf link), which were reported to be at a seasonally adjusted, annualized pace of 421,000. This was an increase of 14.6% over July's 390,000 seasonally adjusted annualized rate. However, and this was not mentioned in the financial media reports I read, July's reported number - and recall that July's new home sales literally plunged nearly 13% from June - was revised even lower from 394k to 390k. July, in other words - a month that should be one of the most seasonally robust - was an outright disaster for new home sales.
There should be no surprise that home sales numbers for August should look good on the surface. After all, August historically is usually either the second or third strongest month seasonally for home sales. I will point out that, according to Bloomberg, Wall Street's consensus estimate for August new home sales was 425k. So the reported result actually missed expectations.
Let's dissect the numbers. First, recall that new home sales are recorded by the Census Bureau when a contract or a sales agreement is signed. This is why prior reported numbers are usually revised significantly lower, as a lot of contracts ultimately are cancelled. For instance, and I'll get to this in a minute, KBH reported a 33% cancellation rate yesterday in its latest quarterly report.
Referencing the pdf linked above, if you scroll down you'll find the "not seasonally adjusted," actual data listed by month. Note that the Census Bureau is reporting that 35,000 actual contracts for new homes were signed during August. If you scroll down further, you'll see a table which breaks out the unadjusted data by stage of construction. Note that, of the 35k in reported sales, only 11k are completed and 24k are either not started or under construction. Based on scanning several recent homebuilder 10Qs, it's safe to assume at least 20% of the contracts on those 35k homes will cancel. This means that 28,000 homes will likely be delivered.
Even if I simply project this number out over 12 months, the simple math implies that the actual number of new homes sold over the next year would be only 336,000 vs. the 421,000 annualized number reported for August that is based on contract signings and not actual deliveries. Given that my simple math projection does not adjust for seasonality, and therefore is likely too high, this example illustrates the difference between what the Census Bureau is reporting for new home sales based on estimated contracted signings vs. the significantly lower number that actually gets delivered. The point here is that, in my view, the homebuilder stocks are trading at market caps that are based on expectations for future home sales that are way too high.
Moreover, the median price for a new home dropped from July to August. In fact, the median price for August hit its lowest level since January. Not only that, but the median price for a new home is down 9% from its April peak. A falling price is not the attribute of a market that is in recovery. I would argue that homebuilders, which have been letting their inventories swell up, were forced to cut prices in order to move inventory and make their price more affordable in light of higher interest rates. Many homebuilders are heading into the seasonally "dead" period of the year with huge inventories. This too is bearish.
This brings me to the KB Homes quarterly earnings report from yesterday (Fiscal Q3 ended 8/31 - pdf of the SEC 8-K filing). KBH reported earnings which exceeded estimates. However their revenue number missed by quite a big margin ($549mm reported vs. $569mm expected). Worse, net orders for new homes declined 9% year over year and its backlog of homes on order dropped 3%. For me, besides the big drop in new orders, the biggest problem for KBH is that its cancellation rate spiked up to 33% from 29% in same quarter last year. Essentially one in every three contracts that KBH signed is getting cancelled.
As opposed to the Census Bureau, homebuilders record revenues when a home is delivered and paid for/financed. KBH's quarter was for June, July and August. This means that revenues were based on closings for contracts that were signed anywhere from mid-April to mid-June (it takes about 6 weeks to close a new home contract). This means that KBH's quarter was likely heavily skewed toward contracts that were signed before the big interest rates spike in late May, which tells me that KBH's next quarter will likely disappoint.
While KBH did not provide a cash flow statement in its 8-K filing, I went ahead and did the heavy lifting in order to see what was going with KBH's cash balance and inventory. The Q3 8-K is linked above and here's the Q2 8-K if you want to see how my numbers are derived. You'll note that KBH's cash balance declined by $155 million. Inventories ballooned up by $220 million. Not much else changed, which means that, in an environment in which KBH's new orders are dropping and its cancellation rate is moving higher, KBH is spending earnings plus cash on more inventory. This is occurring while the market is going into the slowest period of the year for home sales.
The reason I wanted to review KBH's earnings report is that, for me, KBH's situation is representative of the trend in the market for new homes and the overall trend for the housing market. In other words, the bulk of the good news for the housing market over the last 18-24 months is now in the past and the housing market will face significant headwinds going forward, not the least of which is higher interest rates and a middle class which is experiencing declining real monthly income. One more point about KBH, the most recent insider transactions were two large sells in May by an executive who sold over 35,000 shares just above $24 (current price is $18).
On this basis I am reiterating my call use any bounce in the housing stocks as an opportunity to sell long positions or establish short positions. I never expect to leg into a short position at the very top of a trend, so I always give myself room to double down (or "double up" in the case of shorting). For instance, I shorted DHI originally at $23.85 at the end of January, when the DJUSHB (Dow Jones Home Construction Index) was at 516. It eventually ran up to 550 by mid-May but along the way I added to my DHI short in a couple spots in the high $26 area. DHI currently is trading at $20.35 - a 25% gain on the average cost of my short position - and has been as low as $17.52.
Similarly with KBH, I shorted some yesterday at $18 and a little more at $18.25 this morning. One caveat with KBH is that the short interest in the stock is currently at 23.6% of the float. On the scale of short interest ratios, this is a high short interest position which leaves anyone short potentially exposed to a short-squeeze. I'm willing to bear this risk because I think KBH is fundamentally one of the weaker homebuilders still trading in the double digits and it caters to the weakest financial segment of the middle class buyer. With both DHI and KBH, I plan on holding them until they go at least below $10. Both stocks hit $5 in November 2008. You can see some of my other trading suggestions for taking advantage of a bearish view on housing in all of my previous posts. At some point I will update my DHI report from January and I will publish an in-depth report on KBH.