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Welcome to Wall Street, where sometimes it pays to be a contrarian, betting against the crowd and the chatter-box. Such was the case in August 2005, after the Dow Jones Home Construction Index, a gauge measuring top U.S. homebuilder shares, had quadrupled in value over the previous 3 years to set a record high of 1,120. Only contrarians with very deep pockets were talking about shorting positions in the red hot housing sector that buried multitudes of bears in their graveyard.

In June 2005, the median U.S. home price had surged 51% to $219,000 from November 2001, according to the National Association of Realtors [NAR]. The 15% jump for the year ended June 2005 was the biggest 12-month gain since 1980, fueled by rampant speculation in real estate. The market value of owner-occupied homes had risen to $18 trillion from $8 trillion in 1995.

Housing was the locomotive driving the U.S. economy in 2005, accounting for 40% of the 2.3 million jobs added since the 2001 recession. Lehman Brothers said related industries accounted for a third of U.S. economic growth in 2004. But on July 21, 2005, former Federal Reserve chief Alan Greenspan warned banks and speculators that home prices were “unsustainable” in some regions of the U.S.

Home price appreciation in the second quarter of 2005 was led by Arizona’s 48.6% annualized gain, 43.2% annualized in Hawaii, and 33.5% annualized in Florida. The median home price in Los Angeles soared to $446,400, up 54% over the previous two years, according to the NAR. In Riverside and San Bernardino counties, the median price of $296,000 increased 69% over the same time.

But in a speech to the American Bankers Association on October 12, 2005, Greenspan warned bankers that the central bank would persevere with its rate hike campaign, even at the expense of a weaker housing market. “The housing market shows signs of froth, if not a bubble,” he said. But the vast majority of homeowners have a sizable equity cushion to absorb any potential decline in house prices, flashing a green light for contrarians to short-sell highly inflated U.S. housing stocks.

Under Greenspan, the Fed lifted the fed funds rate by an additional 100 basis points to 4.50% before his retirement. His successor, Ben Bernanke, led the Fed with a further 75 basis point hike to 5.25% by June 29, 2006. The laws of gravity gained the upper hand over market mania, though, and the DJ Homebuilder Index saw its last days over the 1,000-mark, highlighting that no market moves in one direction forever.

On May 18, Bernanke and Chicago Fed chief Michael Moskow both noted dangers from the increased use of non-traditional mortgage products over recent years in the housing market. “Up to 40% of U.S. home loans were of non-traditional types such as adjustable rate and no-money-down mortgages in 2005,” Bernanke said. “Some people will soon be faced with adjustable rate loans re-pricing under less favorable conditions.” Five weeks later, the Fed paused its 2-year rate hike campaign at 5.25% after U.S. economic growth slowed to 2.9% in Q2.

One has to marvel at the forecasting ability of markets that move far in advance of the chatterbox news broadcast to the general public. Soon after the DJ Homebuilder Index had tumbled 50% from its all-time highs to the 550-level in August, the media released a deluge of horrific news on the U.S. housing sector. A perfect landscape for short-sellers of homebuilder shares to cover positions.

U.S. new home sales in July 2006 were 22% below July 2005. The supply of new homes available for sale at the current sales pace jumped to 7.3 months in July, the highest since November 1995. In August 2005, builders broke ground on the fewest new homes since April 2003, falling 7.2% to an annual pace of 1.665 million units, down 19.8% from the August 2005 pace of 2.075 million units.

Behind the scenes, homebuilder shares have been tracking the US Mortgage Banker Association’s Home Purchase Index, a real-time gauge of demand for new homes. Coincidentally, the Index tumbled 29% from its August 2005 high to a 3-year low of 375.9 in August 2006. Since bottoming in August, homebuilder shares and the mortgage purchase index have both rebounded by 10%, after the average 30-year fixed mortgage rate fell to 6.36%, down 50 basis points from June, the MBA said.

With the U.S. housing market sliding downward, the odds of an economic recession by early 2007 are slight, but increasing. The key will be the extent to which the slowdown in home sales activity translates into a decline in home prices, eating away household wealth and spending power. Cash-out refinancing by U.S. homeowners in 2005 took a net $325 billion in equity out of their homes.

The fastest-growing component of the earning assets of U.S. banks was home-equity loans, in which houses are put up as collateral. These totaled $399 billion in 2005, up $118 billion from a year earlier. In 2004, 42% of mortgage assignations had piggyback loans to cover down payments and transaction costs, twice the proportion of 2003. However, the Federal Reserve is expected to start lowering the federal funds rate in 2007, to defend home prices and U.S. bankers’ balance sheets.

After climbing to a 25-year high of 365.45 on May 11, the Reuters Jefferies CRB Index, which measures 19 exchange-traded commodities, began to show signs of fatigue in June and July. It then stumbled into a free-fall in August and September. With the CRB index slicing below its four-year upward sloping trend-line in early September, chart watchers would probably agree that a peak in the commodity inflation cycle has been reached.

In the aftermath of the severe collapse of the CRB Index below its key upward sloping trend-line, it doesn’t take an expensive college education to figure that after a few more months of a steady hand, the Fed’s next shift would probably be towards lower interest rates. U.S. housing stocks rose by 10% last week, despite grim news on new and existing home sales, on expectations of easier money in 2007.

Since July, the DJ Homebuilder Index has stabilized and formed a base of support, before jumping 10% higher in the week ended Sept 15th. Housing stocks are also tracking U.S. dollar Libor futures (Eurodollar), which are moving higher, and ruling out any further increases in the federal funds rate this year. It is interesting to note that the DJ Homebuilder Index rallied 10% after Lennar Corp (NYSE:LEN), Beazer Homes (NYSE:BZH), KB Homes (NYSE:KBH) and Toll Bros. (NYSE:TOL) had all lowered their third quarter and full year profit outlooks on Sept 6-7th.

On Aug. 31st, H&R Block (NYSE:HRB) cut its full-year earnings outlook and said its quarterly loss more than quadrupled due to a $61.3 million loss related to rising mortgage defaults. But the subsequent 10% surge in the Homebuilder Index sent a clear message: that contrarians have fully discounted the barrage of bearish news now hitting the U.S. Homebuilder Index, with the 50% discount from its all-time highs. Traders are looking through the front windshield and not the rear-view mirror.

From a technical perspective, it might pay to become a contrarian and buy U.S. homebuilder shares, following a 50% Fibonnaci retracement from the all-time high of 1,120. Furthermore, the DJ Homebuilder Index reached its downside target of 550, as projected by the “Head and Shoulders” Top pattern noted above. With the Federal Reserve gaining breathing room to lower the fed funds rate in 2007, due to a 20% drop in crude oil prices since August 8, and gold tumbling under $600 per ounce, the odds of a housing sector rally in the months ahead are looking up.

Gary Dorsch may have a position in the securities mentioned in this article.

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Source: Contrarians Moving Into U.S. Housing Stocks