A Critical Review Of Homebuilder Stocks And Housing

by: Markos Kaminis

The general view of housing is decidedly positive heading into the 2012 spring selling season… as usual. It is positive compared with other recent spring selling seasons as well, but not by much, given the generally speculative hoping that occurs among industry participants around this time of year. The mood among homebuilders is also improved, though notably depressed still on an absolute basis. That is because it measures the small, under-capitalized, poorly performing construction outfits alongside the large, well-capitalized, publicly traded industry leaders. Furthermore, many publicly traded, large builders like D.R. Horton (NYSE: DHI) and K.B. Home (NYSE: KBH) have been posting increases in orders of varying degrees over a low set bar, though cancellations persist. These factors, helped by capital flow drivers (tax driven mostly), have many stock market players quite frenzied, with homebuilders' shares among market leaders. The SPDR Series Trust Homebuilders ETF (NYSE: XHB) is up roughly 62% since the industry trough on October 3, 2011, adjusted for dividends and splits. The ETF is up roughly 18% year-to-date, separating itself clearly from the approximate 7.4% increase in the S&P 500 Index. My review here is to take stock of what has given the industry lift to date, and to survey its footing for the months ahead.

New aggregate industry data has been reaching the wire this week, and it seems to concur in its message with that of recent weeks. The argument the data makes is clear, and definitely contrary to the performance of homebuilder shares (if you read beyond the headlines), which I argue have benefited as much from unsustainable capital flow drivers as from fundamental improvement in the housing industry. Furthermore, the macroeconomic outlook remains grim and the trend seems to show deterioration. So, I once again argue that sooner or later, at least a portion of homebuilder valuations built largely upon capital flow logic and prospective hope is likely to give way before propelling much further on momentum. I see speculative interests, which may view themselves as wise contrarians at risk by result. But this logic extends beyond just homebuilders, to all cyclically sensitive shares that have moved in kind.

Homebuilder confidence was touted Wednesday as yet another rally cry for the industry's shares. The National Association of Home Builders (NAHB) reported the fifth consecutive month of improvement in its Housing Market Index. But while the HMI was climbing to a mark of 29, from 25 in January, it was still sitting deeply under the mark that delineates positive outlook from negative. In fact, while the HMI may be off suicide watch, it remains in a sad, sad state.

Looking at Wednesday's weekly mortgage application data, I found nothing worth celebrating. The Mortgage Bankers Association's Market Composite Index only fell by 1.0% in the week ending February 10, 2012, when compared against the preceding week. Refinance activity was up 0.8% for that relative period, but the mortgage applications tied to the purchase of a home fell 8.4%. Believe it or not, though, the weekly decline was probably the result of the Super Bowl, which fell on February 5. More importantly, the Purchase Index was 7.6% short of the mark it set during the same week last year. That comparison is clearly inconsistent with the profits accumulating in the shares of homebuilders in aggregate.

Housing Starts, reported Thursday for the month of January, gained by 1.5% over December, and ranked 9.9% above January 2011. Even here, yours truly found reason to argue. You see, single-family housing starts actually fell 1.0% against December. The growth was found in multi-family units of 5 or more, where construction increased by 14.4%. A shift toward a renter nation is not indicative of a healthy atmosphere, though demographics are aiding the growth of the senior housing industry, as seen in the long-term chart of the Senior Housing Properties Trust (NYSE: SNH).

Looking back two weeks at the latest home price data, the Standard & Poor's Case-Shiller Home Price Index showed acceleration of home price decline in November. The data was downright depressing, with 19 of 20 cities experiencing a second consecutive month of price contraction. However, many builders like Lennar (NYSE: LEN) are showing sales price increases alongside volume gains, thanks to differentiation and buyer focus between the lean new home and flooded existing home markets. This is a second fundamental point, which is positive for publicly traded builders, and I will not overlook it. It is certainly one tangible reason why homebuilders have attracted capital to date. However, I do not believe it will guard the high beta shares from macroeconomic driven slippage and geopolitical trigger. Perhaps these fundamental factors will contribute to an industry wide beta contraction though, as the industry has strengthened through trial.

Another bit of good news for homebuilders is that their own version of austerity has shaved their inventory and that of the home market, in terms of months to sell through. Furthermore, Realtytrac sees the foreclosure cycle peaked, so the flow of low-priced comparables into the pool of available properties is easing. Still, the industry resource says banks continue to work through their own stock of "delayed foreclosures." Also, new foreclosures continue to flow only less heavily into the market, given the still difficult labor situation and strained savings of the long-term unemployed.

Better capitalized, large, publicly traded builders are also benefiting from market share gains helped along by the demise of a good number of smaller builders that found themselves over-levered with nowhere to sell at the bust of the bubble. These changes to the composition of the new home construction pie are likely contributing to the the order growth and other gains reported by the likes of Beazer Homes (NYSE: BZH), Toll Brothers (NYSE: TOL) and others. This is a fundamental reason to like home builders over the long run.

Another contributor to growth for the public builders is the low base, which today's activity is rising from. That fact comes through in the cautionary commentary of the executives within the reports referred to herein. The prospect for industry revival through its contraction and given the signs of survival in many of the healthier builders has the most prospective of the bunch gaining more ground, like that seen at Hovnanian (NYSE: HOV) and Comstock (NASDAQ: CHCI). These are the first places I would look to lessen risk, if not outright position short.

Industry structural change factor aside, I believe these stocks (and other cyclically sensitive sectors like retail stores - which I recently suggested investors short) are going to need ongoing support from the economy to keep capital support. I just see that failing them given signs of new U.S. economic sluggishness, stubborn unemployment on labor market structure issues, European recession and an Iran event likelihood that can no longer be dismissed. The vulnerability of the U.S. economy to costly energy (rising gasoline prices), disruptive geopolitical disorder and significant export softness, given still too high under-employment and too low consumer confidence and business investment leaves cyclical industries in tenuous state.

The chart of the XHB says to me that the latest run up for homebuilders is at a point of reassessment. While the individual corporate reports of the healthiest publicly traded companies should continue to offer general support, many names will disappoint high hopes. Furthermore, the operational results bar has been raised now for these stocks, which increases the likelihood of their falling short of expectations. Given the aforementioned macro weights, cyclical shares should give way. Highest on the hill among those are the recently raised homebuilder stocks, and so I reiterate my call to sell the shares despite the evident driver of structural industry improvement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.