Get Ready to Short Homebuilders

Yesterday, I explained short-selling as an investment strategy. Today, I’m going to explain my favorite short-sale. Be warned, if you, like the Wall Street CEOs, believe that the “worst is over” in terms of the US credit contraction and housing bust, you should stop reading now.

I think investors should short homebuilders.

I’ve grown increasingly bearish about this sector in the past couple of weeks. My reasons are as such:

1. Housing prices need to fall an additional 25%.
2. Inventory is at historic highs and won’t diminish until prices fall further.
3. There is far too much bullishness for the sector

None of these items are new news. However, the third is the only thing stopping the first two from having an impact on the market. This won’t last much longer.

Many commentators have made a big deal about the fact that homebuilder stocks are trading 50-70% off of their recent highs. I don’t see the value to this insight, since homebuilders’ recent highs were also their all times highs. And those all-time highs were spurred on by the biggest housing bubble in the history of this country.

According to the “buy ‘em cause they’re down” philosophy, Tech stocks would have been screaming buys in late 2002, so would subprime mortgage lenders in mid-2007, and Bear Stearns (BSC) in early 2008.

As you can see, mindlessly buying anything that falls dramatically would produce quite a track record.

The harsh reality is that homebuilder stocks still have much further to fall (see Monday’s essay for more on this). The Fed can pump as much money as it would like into the financial system, but none of it will go to homebuilders. The trickle down of liquidity goes as far as the banks and that’s it.

And while home sales and prices have fallen, inventory remains at or near historic highs. Put another way, the fact that homes are cheaper hasn’t resulted in increased sales. In fact, research by Calculated Risk reveals current excess inventory at around 1.6 million units. So, there are 1.6 million units above and beyond the usual inventory levels in this country. You can read more on this here.

Aside from this, there is simply too much bullishness surrounding homebuilders. The sector has rallied nearly 25% since its January lows. Numerous financial commentators— I’m not naming names— have stated we’ve hit a bottom. I notice most of these guys don’t make any mention of home prices relative to incomes, inventories relative to sales, or any other meaningful analysis.

To me, homebuilders are ripe for short-selling. And while stocks can take quite a while to rally, downward moves tend to be quick and dramatic. Because of this, timing is everything. From a technical analysis-standpoint, DR Horton’s (DHI) time may have come.

As you can see, shares of DR Horton nearly doubled in January 2008. The stock has since entered a consolidation phase between $15 and $17. It now looks ripe for a breakdown— this recent rally isn’t showing the same strength as the others. If DR Horton shares break below $15, we should see a quick drop to $13.

The story is the same for other majors like Pulte (PHM) and Beazer (BZH). All of them exploded upwards in January and since have been struggling to gain traction. To me, all of them look like prime candidates for a quick short sale.

In the near-term, the market is driven by idiocy and speculation. However, in the long-term fundamentals and data win out. The recent rally in homebuilders has been driven primarily by the first, not the second. Investors finally seem to be realizing this.

When they do, the correction will be both quick and dramatic.

Disclosure: none

Comments

[apppro]

Get Ready to Shut the Heck Up

Enough with you bloggers who get put up on "News" links. Enough already. Get a real job! Unless, that is as a short seller, spreading rumors and false info is your job!

[RogerRiggins]

What is happening in the resale market bodes well for homebuilders. Finally there is a surge (in some markets) in sales of low priced homes due to pent up demand for affordable housing which until recently was priced out of reach of many buyers. Now that the foundation of the market is moving, that sets the stage for the houses priced in the next tier to see an increase in sales as the sellers of the lowest priced houses move up into that bracket. It may take a little while for the effects of this to be shown in the statistics, and even a little longer for homebuilders to benefit from this phenomenon, but the market has already begun moving positive.

[Jon G]

What would govt bailout of homeowners that Gross et al are arguing for do to your thesis - it's coming IMO

[User 167165]

My sister is a realtor in FL and what I can tell you is the buyers she reps are now loosing out because of multiple offers on homes. This is not a rare occurance. Homes that are priced at the market or slightly below are going to multiple offer transactions. One of my clients works for a shell building company and their business has increased each of the last 2 months. Orders for 150 homes have been placed buy a large new contruction builder. As a resident in FL I think the condo market has further to fall (not much), but the 3/2 single family is at or past bottom.

[DCM]

I wish someone could explain to me where the buyers are going to come from to buy this historically high excess inventory. The housing bubble was created because people who previously could not qualify for a mortgage (poor credit, insufficient income, no down payment) were financed with sub-prime mortgages. Assuming that millions of people will not be back in the market or will now be unable to qualify for a mortgage, where exactly are these buyers going to come from?

The reason we have an historically high inventory is because there are fewer qualified buyers. Most potential buyers are not waiting on the sidelines for prices to fall further (i.e become more affordable.) Most are not buying because they cannot sell the homes they live in now! It is going to take an unprecedented number of qualified first-time home buyers to soak up the current excess inventory of homes. Given the new (old) lending standards, it does not seem likely that this is going to happen anytime soon. This is one time I hope I am mistaken and am missing something here.

[Gob]

DCM, has a great, common sense point.

[User 194013]

DCM can see his common sense logic unfolding in the US' single most often identified stable housing resale market - inside the beltway Washington, DC.
Inside the beltway was Declared "recession proof" in 73, "job loss proof" in '81, and "resale proof" in 91 - and so it was - until now.

For the first time inside the beltway housing resale prices are falling "across the value spectrum - $2m to $500k" -and for the most simplistic of reasons - the very ones identified by DCM. The insided the beltway realtors, Long and Foster, Weichert, etc - were at first stunned, then in denial but now at last have begun telling inside the beltway sellers "cut the price" or keep the house.

[eh]

In many areas a majority -- in some cases a large majority -- of the lower priced homes that are moving are REOs. This does nothing for the so-called move up buyers, or those who want to be one.

[bscgovman]

Inside the beltway Washington DC
Declared "recession proof" in 73
Dclared "job loss proof" in 81
Declared "resale loss proof" in 92

For the first time Inside the beltway resales across the value spectrum from $500k - $2m are now "not proof". In 06 the beltway realtors, Long and Foster and Weichart were stunned, In 07 they were in denial, in Spring 08 for the first time sellers are told "cut the price or keep the house- and pray, pray, pray". The buyers have vanished.

[John Egan]

I buy the article... We;ve had two large builders in Sacramento go belly up so far. I suspect that the Fed has pretty much done what it can, and the 'stimulus package' will be a short lived romance. Although I don't see a lot of evidence that we're in for a big recession, I do see more unemployment and business cutbacks coming. Again, in Sacramento, Apple is closing one of its divisions which will result in a 2400 person drop, and with a a $14 Billion shortfall, Calif will be sending out pink slips.. The story goes on... Across the country, banking, real-estate and business services are hurting. Lets face it, the bright spots in our economy are energy and basic materials. As we've really become a service sector nation, where will the money come from to buy these homes...

To further complicate matters, resellers are beginning to realize that they do have to drop their prices. My inlaw just passed away a year ago. The home went on the market at $630K and price was dropped periodically. The home was then completely remodeled and just sold for $430K. This is in a nice neighborhood. My neighbors in Sacramento sold their home last year at a discount! $219K. Presently the market os flooded with bank REOs at $140K. And yes, I do know that the main areas impacted are Ohio, Florida, Nevada and California.. because those were the boom areas.. Guess what. That's where the homebuilders have the bulk of their inventory too...

If you are long homebuilders... Buy some protective puts. If you are bottom fishing, re-read the article..Or at very least, look for homebuilders in areas that 'appear' to be away from the areas of potential damage. Take a look at the chart for Uranium enricher USU for a feel of what could be...

'Always look on the bright side of life... ( Monty Python - The Life of Brian) jegan ;-)

[cazzman]

Yeah great advice. Have you actually trying shorting any of these stocks? I have and they don't go down...ever! No news is negative to this sector. While I can't understand why there's any optimism at all, I wouldn't touch these stocks!

[John Egan]

cazzman's right! Ha! Ha! I've lost more money playing the Ultrashorts in finance, housing, China and energy than on my kids! I guess the market is not as efficient as some thinkle peep it is!!

Bye jegan ;-)

[DC HousingBear]

John, maybe the fact that you haven't been able to make any money from speculating means that the market is actually MORE efficient than you think! But maybe that was your point.

I won't touch these stocks anymore either, really hard to tell where they go from here. Speculators could push them higher on BAD news that's not as bad as expected. Go figure.

[Kunst]

We need to keep in mind that the new-home and resale-home markets are different. During the bubble, both shot up to the sky. The problem in the resale market is that an awful lot of people have little, no, or negative equity in their house, either because they bought in the last few years and prices have dropped, or because they refinanced up to the 80% level of a value that has since dropped. If you don't fall in either of those categories -- you bought a while ago and didn't go to the refi ATM -- then the only problem is that your house is worth a lot less than it might have been a few years ago. Not that big a deal, especially if you are buying another house in the same market conditions.

Housebuilders have and had a different situation. A builder who started the process while the bubble was developing got a huge windfall when prices shot up. If Mr. Builder was planning to make and sell a house for say $200K, with a reasonable profit, all of a sudden he can sell the same house for $300K by the time it is finished. The increase is pretty much all profit. Now late in the bubble, he might have overcommitted and gotten burned by higher land or building costs, but the basic fact is that building costs never went up to the degree that house prices did.

That leaves significant room for builders to come down in price to sell finished houses, since their costs are more akin to pre-boom times. Much of this is disguised by indirect price cuts -- free upgrades and such -- but the bottom line is that builders have a lot more room to drop prices than the underwater home owner, and less emotional attachment to excess profits that may have been "real" at one point but certainly are not now.

A lot of home owners either can't sell for enough to pay off the mortgage, or are still so invested in what they thought their property was worth a few years ago, that they will not price their house so it will sell in this market. A lot of sales are by those who have to sell, due to death, divorce, job loss, relocation, etc. Many of the others are going to sit on their property until it "goes back up".

Home builders have no such illusions. They will sell at market because carrying inventory costs them. The key question for the homebuilder stocks is whether they can build and sell new homes profitably under current conditions. Given high material (but not labor) costs, an overhang of inventory, and a shortage of buyers, it really doesn't look like a very promising proposition.

It is hard to see how building and selling houses is going to be a good business for the next several years. Too much housing was built during the bubble, borrowing requirements have been tightened, consumers are stressed by high energy and food costs coupled with flat (or worse) incomes. Supply and demand, isn't that the fundamental issue? Too much supply, limited demand. How can that be a healthy business environment for builders?

The House bailout bill won't change this much. Its intent is to keep people in their underwater houses and prevent foreclosures. It isn't going to do anything to bring more buyers into the market.

With the unjustified run-up of builder stocks since the first of the year, I'd rather be short than long.

[special1person]

"For the first time inside the beltway housing resale prices are falling "across the value spectrum - $2m to $500k" -and for the most simplistic of reasons - the very ones identified by DCM...."

Not entirely true.

The houses "inside the beltway" that are in SUBURBAN locations far, far, far away from the places where people want to go to eat, drink, play, work, etc are...going down.

HOWEVER, the locations "inside the beltway" that are in URBAN locations close to the places where people want to go to eat, drink, play, work, etc are...going UP, UP, UP:

Home Prices Drop Most in Areas with Long Commute
www.npr.org/templates/...

It's the same in any DESIRABLE urban city:
"Los Angeles, San Francisco, New York, San Diego, Miami and Boston."

If you live in OK City, Indianapolis, Kansas City or some other broken down "burg", forget-about-it. You choose to live in "nowheresville&qu... and now you will be paying the price for it.

The kids of the Gen-X'ers, the so-called "Millennials"... don't want to live in the Burbs.

Bo-ring.

[Takayama]

Short-sellers beware. Learn from your losses and polish up your techniques.
When there is no desperate sellers, the stock price will rocket to the sky. Trust your inner voice.