Are Homebuilders Ready for Another Drop?

Homebuilder stocks look prime for another drop.

Back in mid-May I recommended short-selling homebuilders, citing DR Horton (DHI) as a particular stock that was ready to roll over. My reasoning at the time was simple: Commentators had once again begun calling for a bottom despite the clear fact that the industry’s fundamentals were deteriorating.

None of the bottom-callers made any mention of actual fundamentals. No one explained how homebuilders would sell homes when banks were no longer lending on favorable terms and consumers had little or no savings to use as a down payment. Instead, the primary argument for a homebuilder bottom was that “homebuilder shares had fallen more than 70% from their highs.”

The problem with this kind of “analysis” is simple… no matter where a stock is trading, it can always fall another 100%.

Until something trades at $0, it can always fall further. Gerard Minack of Morgan Stanley (MS) once said that the definition of stock that has fallen 90% is “one that’s fallen by 80% and then halves.” I’d add to Minack’s sentiment and say that even if an investment has fallen 90%, it can still fall another 100%.

So the idea that homebuilders are somehow cheap because their shares have fallen more than 70% is no basis for a long position in the sector. Seeing the increased bullishness amongst market commentators as well as the worsening fundamentals and weakening rally in homebuilder stocks, I recommended shorting them on May 15. Within two weeks, the next wave of foreclosures hit, more borrowers became delinquent, and homebuilder stocks took a nosedive. Shares of DR Horton fell some 40% in a month and a half.

Which brings us to today.

Homebuilder stocks—along with financials— kicked off a tremendous rally in mid-July, thanks in part to the SEC short squeeze and Hank Paulson’s then-implied intervention with Fannie (FNM) and Freddie (FRE). This rally, like the last one (March-April), was driven primarily by sentiment. The fundamentals for the industry, if anything, have worsened.

Over the weekend, Bloomberg announced that foreclosures hit another record in August, with one in 416 households receiving a default notice. Home prices have fallen nearly 16% in 20 US metropolitan areas during the 12 months ending June 2008. There are now 3.9 million unsold single-family homes sitting on the market— a 26-year high.

Looking at these two trends—worsening fundamentals and irrational enthusiasm on the part of investors—homebuilders look ready for another short-sale. And this time around, it’s Pulte Homes (PHM), not DR Horton, who looks ready to roll over.

As you can see, shares of PHM have gone virtually parabolic in the last week. However, this red-hot rally is showing signs of cooling— the stock has failed to break above $16.30, a major point of upward resistance, twice now. In light of the wave of awful news released over the weekend (see foreclosures info above) I wouldn’t be surprised to see PHM shares test $15 or even $14 in the next two weeks. There is no real reason why this stock should be testing its 52-week high, especially considering how terrible the climate has become for selling homes.

Comments

[blah blah:]

I'm of the same opinion, perception has to fall back to reality at some point. Pulte is up even though Citi downgraded based on valuation concerns. I'm short as of today.

2008 Sep 15 10:53 AM

[SHartwell:]

The author makes much of the fact that a stock that goes down can always go down some more. He says that you can't like a stock just becasue the share price has fallen. How true.

He then bashes XHB and PHM primarily because they have gone up.

This is the other edge of the same sword. While it's pointed out that a stock that's gone down 80% can still be cut in half, the author neglects to point out that a stock that's doubled can always double again. And again. In both cases, however, the sword the analyst is using is the sword of fools.

Yes, homebuilding still faces hurdles. But, with the Fannie and Freddie takeovers, 30-year mortgage rates have gone from 6.40% to 5.80% - an astounding 10% increase in affordabilty in just one month.

Oil prices have dropped from nearly $150 to $100, freeing up disposable income to potential home buyers.

And, while existing home inventories so far remain stubbornly high, we are finally building new homes at a rate much less than the annual demand increase from our ever-growing population. So new home inventories have declined, and declined dramatically.

We're certainly not out of the woods yet, but with valuations in most cases well below (written down) book values, and with most of these companies now cash-flow-positive, the 'cost of waiting' is low.

This is unlike many of the financials now going under. They needed capital, desperately. Here the 'cost of waiting' was much, much higher. Indeed, the market won't let them wait it out - hence bankruptcy.

2008 Sep 15 10:57 AM

[mwatch:]

The article make great point of how hoe builders are swiming against increasingly bigger tide. I want to add to what the financial part of the series of problem these builders have to deal with. On the supply side, the market is sitting on a huge unsold inventory, and with the next wave of foreclosure this unsold inventory will get even bigger, additionally, with what just happen the financial industry this past weekend, buyers will have second thought before they make any commitment. The question now is how and when the builders can return to profitability. Should we start using something like 5 year-forward PE forecast instead of one year?

2008 Sep 15 02:42 PM

[lichen:]

The way i see it is that home price are going down, poeple are loosing there jobs, the lending leverage practice is history for few years. The only way pulte homes can maintain his cash position is by reducing his inventories that is melting like ice on a very warm day. But still, how is the valuation done for that type of inventory? I don't see any improvements yet. For the third time, i'm shorting it. There's no reason for me to believe that the valuation of this company would improve in a near futur. The balance sheet isn't improving. In those time i prefer to be in non-cyclical stock's like CHD. But not long in homebuilder's it's like puting your money in a waiting room. There's no predictable growth expected for a while. I don't see a quick turnaround. Even if the stock has to break the resistance stated in this article. My other question is, will it last ?

2008 Sep 15 10:21 PM

[Greg Weston:]

Very good article. I hope to do a balance sheet and cash flow analysis on some homebuilders in the near future.

2008 Oct 01 03:06 PM