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Housing stocks are getting beat up. The latest report from one of the major builders, D. R. Horton Inc. (DHI), added another punch. Horton saw a 23% decline in orders compared to the same quarter last year. Analysts thought the decline would be 18%. The good news was that in the prior quarter the decline was 25%. So is the worst over?

Hard to tell. So much has to do with the psyches of buyers. When they're feeling optimistic, they want to own a home of their own. They know it's a good investment over time. Home sales are also a function of interest rates. When they're lower, the universe of qualified buyers increases and so does demand for houses. How well you can read the American psyche and the future of interest rates will tell you whether the worst is over for homebuilders.

Of course, no one can foretell either of these. But facts are still unfolding to help see how and where profits are going. One of the major indices of future sales is land-related write-downs. Builders will announce them over the next month. Last week, Lennar (LEN) announced it would probably take between $400 million and $500 million in land-related write-downs, one of the largest numbers for any of the builders. Now the spotlight turns on Horton, Centex (CTX) and Toll to see what their write-downs will be. Builders take these when land and home values fall significantly, and it becomes financially impractical to build a home on the land. Keep an eye on land-related write downs for the next clue in the direction for housing stocks. When they're announced (and each builder will have its own numbers, some better than others due to geographic location or market sector), investors will be buying the stocks with the lowest write-downs, selling the stocks with the highest ones.

Homebuilders built up their inventories in anticipation of continued buying. Buying became a frenzy in parts of the country, none more than Florida where condos were bought before they were finished only to be sold to another buyer when they were. The problem was that the music stopped. With too many houses and condos on the market and fewer buyers (and no speculators left), builders have 2 options: they can take their houses off the market and hope for the best. Or they can cut prices and/or increase incentives such as upgrade appliances or better rugs or help with the financing. All of these latter options decrease profit margins. As of the end of November, there were 169,000 units nationally of completed homes, a new record. That would suggest several more quarters of earnings weakness.

There is some optimism from the builders themselves. Toll Brothers (TOL) stated it believes conditions have bottomed out in certain of their communities. The supply of unsold homes has decreased from 7.2 months in July of 2006 to 6.3 months in November. Other factors that will help the home builders: an increase in the stock market, even lower unemployment, lower interest rates and immigration.

Probably the best indicator for investors will be when the builders stop incentives and/or cutting prices to move homes. That says demand is increasing to a point where those incentives are no longer needed. Since some areas of the country will rebound early, it's important to know which builders are concentrated in what region and to know where the incentives have stopped. When that happens, increased profitability will show up in one or two quarters. But the stocks will react long before the profitability becomes visible.

Disclosure: Author has no position in above-mentioned stocks.

Source: Housing Stocks: Is the Worst Over?