Not Yet Time to Buy Homebuilders

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 (DHI), Beazer (BZH) and Pulte (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.

Comments

[gaucho]

We are in 100% agreement. This bubble took 5-8 years to build and it is not going to go away within 1 year. I think that the housing market is dead until at least 2011. It may take longer depending on how much the economy tanks. I think thatr realistically we could see a recession lasting 7-10 years. We will get sucker rallies like today whwre every one want to rush in and buy. Take this as another opportunity to short.

[karchad]

I so disagree. If you are a long-term investor, how can you NOT buy a sector that is down 75-90%????? Sure, wait, wait till you hear good news. Wait till the sector is up 50%. Don't believe me? ITB fell to about 13.3 in January. Now it's in a trading range between 17 and 20. So, already you've missed as much as 50% of the gain. Not yet time? As a long-term investor, now is precisely the time. Did I catch the exact low? Of course not. I bought at 16. Will you catch a bottom with that advice to wait.? Not even close. If you wait till everyone is buying homes, you are way way way too late. It's opinions like the above that cause investors to alway buy high, and sell low in panic. After 40 years of investing, I've learned my lesson.

[gaucho]

You said "If you are a long-term investor, how can you NOT buy a sector that is down 75-90%????? Sure, wait, wait till you hear good news. Wait till the sector is up 50%. Don't believe me? ITB fell to about 13.3 in January. Now it's in a trading range between 17 and 20. So, already you've missed as much as 50% of the gain. Not yet time? As a long-term investor, now is precisely the time. Did I catch the exact low? Of course not. I bought at 16."


You should buy a sector that is down 60-70% since much of that runup in price has happened in the last 3-4 years.

The bottom of the housing fall will not happen for at least 2 years. Most of the recent run-up was the result of fools like you thinking this housing crisis was going to end by the second 1/2 of this year.

This is a long term bear market and stagflation is arriving now. Keep buying so when you finally capitulate I will get the most gains.

[nofactor]

It's probable that this secular bear market will go on for some time. However, take into account that markets usually trend only 30% of the time, so my bet is that we will be navigating a really boring range-bound market for some time. Once volatility decreases, stocks may start to regain positions.

[User 34323]

I agree with gaucho 100%!! You have to be a "IDIOT" to buy housing stocks now! If the bottom is near,then why are those CEO,s dumping there stocks?

[docman]

I disagree with your assertion. There are several reasons to think that the homebuilders are a good investment now:

The homebuilder stocks have been falling for 2 years straight, and the PE ratio of these stocks is now less than 50% of the average US stock (XHB PE ratio is 6.6).
The US housing market will not fail in the long run (i.e., 10-20 years). Real estate may go out of style for awhile, but it is unlikely that there has been some "fundamental"... change in the real estate cycle (beware those who say "this time it's different!").
Sure there was a bubble. Then there was a correction with a 60% drop in homebuilder stocks over 2 years (check out a 3 year chart of XHB)... Now there will likely be a lot of upside over the next several years as this sector crawls back to fair value. Currently the worst case scenario for real estate is priced in.
The question in my mind is not "has real estate in the US hit the bottom?" but "Are homebuilder stocks a good deal now and are they likely to outperform the rest of the market in the future?" Given the massive drop in stock prices, gloomy public perception which is "priced in" to these stocks, and the fact that long term, the US housing market will not fail all lead me to conclude that for a long term investor, homebuilder stocks are probably a good opportunity right now.

[Tim Plaehn]

The average recession in the U.S. lasts 9 months, now probably 1/2 over. Anyone who thinks the recession will last 7-10 YEARS is clueless about economics.

[pairadox]

"People who time the market get killed..." "Timing the market is a fool's game". Those are comments made with reference to buying stocks when the news is pessimestic. But isn't declaring "the recession has just begun" also timing the market? When it becomes common knowledge that the economy has recovered, home building and financial stocks with be at their 52 week highs. Many will wonder why they didn't buy in at the low point.