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Despite a 5-month low drop in consumer confidence, and the European debt crisis, the recent optimism about the housing data has helped stocks rebound, as is evident from an increase in the S&P 500 index by 0.5 percent recorded yesterday, as compared to a drop of 1.6 percent on June 25.

The primary reason for this optimism is the fact that new home sales have reached a two-year high as mortgage rates have plummeted to record low levels. As a result, homebuilding and refinancing are more attractive options now.

U.S. Single-Family New Home Sales


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U.S. 30-year Mortgage Rates


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A reliable indicator of these impending home sales is the Mortgage Banking Association (MBA) Purchase Applications' Index, which has recently reached its highest level since May 2009.

Reuters reported that the S&P/Case Shiller composite index of 20 metropolitan cities gained 0.7% on a seasonally adjusted basis, exceeding economists' expectations of a 0.4% gain. According to Bloomberg, "The Washington-based National Association of Home Builders/ Wells Fargo sentiment index rose by 1 point this month to 29, the highest since May 2007." This is another good sign for the housing recovery.

According to a majority of economists and analysts, the housing recovery has eventually started after a period of six years, but it has a long way to go amidst weak demand, foreclosures, cooling job market, and limited access to credit. The recent extension of the Fed's Operation Twist program, to keep interest rates low so as to reduce unemployment and boost the housing sector, has also helped accelerate this recovery.

One cause for concern is the declining share of new home sales in the residential market, which dropped to 6.7% last year from 15% during the housing boom, which prevents us from extrapolating the record increase in new home sales to a quick recovery in the overall industry. However the decline in existing home sales, due to a reduction in the number of distressed properties reaching the market, decreases the competition for new home sales. In addition, lower mortgage rates and the Fed's aim of sustaining quantitative easing to bolster employment and housing is a good indication for the housing sector.

Along with this positive outlook for the housing recovery, we believe that those homebuilders, who are able to show an increase in the number of new orders and quarterly backlogs, and a reduction in the order cancellation rates, are good potential investments.

Let us now analyze the stocks of major market players.

Lennar Corp (NYSE:LEN)

We reiterate a long position in its stock due to the following factors, which were also quoted to justify our earlier position:

  1. Its order cancellation rate for this quarter has maintained its low position at 18%.
  2. Its number of new orders showed n increase of 33% on a YoY basis.
  3. The company experienced a decade-high quarterly backlog growth of 39% in the recent past.
  4. Its long-term growth rate was 16% higher than the industry average of 14%.

Toll Brothers (NYSE:TOL)

We have maintained our recommendation of a long position for TOL's stock because:

  1. The company is more exposed to luxury buyers who have better credit records. Therefore, the tightening in lending standards has not had a major effect on the company.
  2. The company's quarterly backlog increased by 37% on a YoY basis.
  3. The number of deliveries increased by 14% on a YoY basis.
  4. The number of new orders increased by 47% on a YoY basis.

DR Horton Inc (NYSE:DHI)

Like most of its peers, the following figures show a positive outlook for DHI's future:

  1. The number of net sales orders increased by 19% on a YoY basis for the second quarter.
  2. The sales order backlogs in 2Q2012 increased by 17% on a YoY basis.
  3. The order cancellation rate dropped to 22%.

However, we believe that its current price is reflecting its upside potential, and the following facts prevent us from recommending a long position in the short-term:

  1. Its PEG ratio, the highest among its peers, is 4.26, and its long-term growth rate, the lowest in the industry, is 5%.
  2. Its price-to-book ratio of 1.75 is the highest amongst the lot.

So, we recommend a neutral position in the short-term, but for long-term investors, DHI can be a potential buy.

KB Homes (NYSE:KBH)

KBH's orders, unlike its peers, have declined by 8% from the previous year, and their cancellation rate has jumped from 29% to 36% on a YoY basis. Also, its liquidity is threatened by the annual decline in cash and cash equivalents of almost 54%. So, due to its weak fundamentals, we recommend a short position in its stock.

Homebuilders' Portfolio

For short-term investors, LEN and TOL are potential buys, while KBH is short. Long-term investors can also take long position in DHI. Another potential short for hedging purpose is the Homebuilders ETF (NYSEARCA:XHB).

Source: How To Play A Bottom In Housing