Time to Start Looking Beyond the Housing Slump

Includes: DHI, HOV, LEN, PHM, TOL
by: Marc Gerstein

It has taken a long time for analysts to become bearish on homebuilder stocks, but now that they've done so, a case can be made that they may be close to souring near the lows. While bad news continues to roll in on the orders, sales, and earnings fronts, the broader rhetoric has recently turned more hopeful, with one Federal Reserve governor describing the downturn as an orderly adjustment and former Fed Chairman Alan Greenspan suggesting the worst may be over for this sector. We're certainly not yet out of the woods: The Fed still is not breathing easy with regard to inflation. But investor behavior suggests increased willingness to start looking beyond the current slump, even if we are not yet able to pinpoint the timing and magnitude of the trough.

While many have been worried about housing for quite some time as prices soared to hard-to-afford levels and as the Federal Reserve pursued its string of interest rate increases, Wall Street analysts remained confident and defended the stocks, citing low price/earnings ratios, share buybacks, large land banks owned by the companies, good cost controls, and so forth.

Ultimately, though, analysts' optimism proved misguided. Table A shows the extent to which they've had to slash earnings-per-share estimates for the past year for such firms as DR Horton Inc. (NYSE:DHI), Lennar Corp. (NYSE:LEN), Hovnanian Enterprises Inc. (NYSE:HOV), Pulte Homes Inc. (NYSE:PHM), and Toll Brothers Inc. (NYSE:TOL). Table B shows generally weak share price performances among these stocks.

Table C shows that eventually, the estimate cuts took their toll on sell-side morale. Ratings have finally become more bearish.

An important miss among analysts was their past belief that low P/E ratios would help the stocks even in the face of weakened earnings.

Table D shows that P/E ratios now are higher than they were a year ago.

Actually, though, this may be bullish.

In his book "Investment Valuation" (Wiley, 1996), Aswath Damodaran reminds us on page 307 that "it is not uncommon for the PE ratio of a cyclical firm to peak at the depths of a recession and bottom out at the peak of an economic boom."

The low P/Es analysts were citing a year ago did not really spell attractive valuations, as they thought. Instead, the ratios came from investor perception of unsustainable, peak earnings power. Conversely, today's higher P/E ratios reflect views to the effect that 2007 estimates represent similarly unsustainable, trough business conditions. And judging by the positive investor reaction to DR Horton earlier this week even as the company announced surprisingly weak September-quarter performance — orders fell 25 percent year to year, although they rose 40 percent from the prior quarter - it seems that investors may no longer be demanding much precision in terms of predicting exactly how far down earnings will go and which quarter will prove to be the low point.

Indeed, the investment community seems to acknowledge that home prices are likely to be lower next summer than they are today. Table E shows the price differences between the most recently released tallies for the S&P/Case-Shiller Home Price index and the August 2007 housing futures (based on that index).

Those who seek to trade options on housing futures find themselves confronted by an extremely one-sided market where, it seems, just about everybody wants puts with nobody wanting calls. Of the 1,416 open option contracts, only 170, 12 percent of the total, are calls.

More stark are the implied volatilities (this being a measure of value in option trading much the way P/E is for stocks, with higher figures in both cases indicating more expensive valuation). We calculate the average implied volatility for the puts as 22.5 percent, but we find that the calls are quoted at an average implied volatility of only 6.2 percent, the latter being the functional equivalent of a very low P/E, meaning lots of potential sellers but few prospective buyers.

However, as we look further out in time, the picture becomes more balanced. Housing futures presently stretch no further than August 2007, but the stock option market shows an interesting turn in sentiment toward homebuilders. Table F shows that as we move from the January 2008 contracts to the January 2009 instruments, there is an increasing willingness on the part of investors to own calls, and to even pay up a bit for them (call options command slightly higher implied volatilities). Note that we look only at near-the-money contract, one strike price above the market price and one strike price below, in order to weed out the impact of "busted" positions established when many held expectations much different from what they believe today.

Table G summarizes growth-rate expectations implicitly reflected in the current prices of the homebuilder stocks we've considered here.

In each case, growth rates that need to be achieved in order for equity investors to break even look reasonable compared with Wall Street consensus expectations. As we've seen, though, analysts have been wrong here before and the break-even growth rates are higher than the lowest published growth rate projections. But considering how much more of an art than a science this sort of forecasting is, and considering the debatability of such general assumptions as betas and assumed P/E ratios, the relationship between the breakeven growth rates and the predicted growth rates seems generally reasonable, especially since the growth rates are calculated with the lower '07 estimates serving as starting points.

There is still downside risk here, but probably not nearly as much as there was a year ago, when analysts were more bullish than they are today.

At the time of publication, Marc H. Gerstein did not shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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