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It’s a matter of taste…

A friend of mine recently purchased an $825,000 McMansion in the suburbs between DC and Baltimore. To him it’s 6-bedroom paradise, a testament to his wealth and success. To me, it’s a sloppily built box unblemished by a single straight line. However, I don’t want to point out the flaws I see, for fear that it would ruin his perception of the place.

I feel the same way about the homebuilder sector at large.

Homebuilders are some of the most distressed stocks out there. The majors—DR Horton (NYSE:DHI), Beazer (NYSE:BZH) and Pulte (NYSE:PHM) — are all down more than 60% from their 2005 highs. Beazer is down a whopping 90%!

The sector has become a favorite for bargain hunters who claim that homebuilder shares will erupt when consumer confidence rebounds and the current over-supply comes down. The fact that homebuilder stocks appear to have staged a bottom in the face of some of the worst new sales, median home price, and foreclosure announcements in years, only adds to the argument.

As was the case with my friend’s house, I see glaring defects in this argument. But they all boil down to one simple notion: People need to buy homes for homebuilders to make money.

Historically, homebuilder stocks have done extremely well when supplies were high and consumer confidence weak. They did this in the early ‘70s, early ‘80s, and 1990.

However, during all of these eras people actually had money to put as a down payment. As recently as 1990, U.S. consumers saved 6% of their income. Today they save nothing. In fact, they spend more than they earn. And with fuel and food prices soaring, I don’t see where the money for down payments is going to come from. Combine this with the fact that banks are raising lending standards, and you’ve got a recipe for trouble.

The average American household makes $48,000 a year. The average home price is $196,000. Where is Joe America, who saves nothing, uses credit cards to pay his heating bills — as 27% of Americans did last winter — and is putting more and more of his income towards food, going to come up with $19-30K for a down payment?

I don’t see it. Neither does Pat McAlister.

Pat makes his living working as a consultant to homebuilders and developers. He’s been working in housing for more than 15 years in every aspect from contracting to building and finally analysis. I called Pat yesterday to see what he thought of homebuilders at large. Here’s what he had to say:

There are two kinds of shifts in housing: cyclical shifts and monumental shifts. We’ve seen the former several times in the last 50 years. However, it looks to me as though we’ve finally hit the latter. This housing bubble was driven by speculation, not genuine home sales. And now the speculators are getting killed. However, their errors are now making things difficult for the rest of us.

Pat’s dead-on here. The guy who bought his house in 2003 and plans to live there 15 years is doing just fine. It’s the flippers and investors who are getting crushed. However, because the financial system is so heavily leveraged, the damage from speculations gone awry can be far reaching. Pat shared a real world example of this:

Recently in Nashville, a high-end custom homebuilder went belly-up. Normally, that would give me pause, but I wouldn’t necessarily get nervous. However, this guy may actually take a local bank down with him, since they loaned him so much money. Now what will that do for the guy who owns a sandwich shop, has nothing to do with the housing bubble, but whose loan was generated by that same bank?

I’ve written about financial markets on these pages before. Pat’s story only confirmed my suspicions that the financial sector is still in trouble. But what about investing in homebuilding stocks?

Housing is like any other investment. People who try to time the market get killed. People who use sound analysis make money. If you’re looking at a housing stock you need to know the underlying business. You can’t simply say that housing in general is a good place to put your money. Housing in general is neither good nor bad… However, the people piling into housing stocks right now seem to be speculating that things have changed. But I don’t see any sound analysis of the businesses themselves to back up these views.

I agree with Pat. I don’t put my money into anything based on sentiment alone. I need to see strength in the business itself. And I don’t see this in most housing stocks. So while the sector may rally in the coming months, I’m not buying. Housing has already fooled people into calling a bottom three times in the last two years. I’m not convinced it isn’t doing the same thing again now.

Disclosure: None.

Source: Not Yet Time to Buy Homebuilders