Shorting the Homebuilders as Their Stocks Surge

Includes: HOV, ITB, LEN, TOL, XHB
by: Whitney Tilson

There's an article in Fortune about the surge in homebuilders' stocks. Bill Miller may be right with his 1991 analogy -- but our money is on the 2001 analogy instead (we've recently shorted the ITB -- the iShares Dow Jones US Home Construction ETF). That year, the previous biggest bubble in history (tech/internet) was in the midst of bursting and the Nasdaq had fallen from 5,028 to half that. Many investors were piling in, thinking that after a 50% decline, tech stocks had bottomed -- but they hadn't, falling an additional 50+%.

Enormous bubbles don't burst cleanly, with prices returning to trend line. A study by GMO showed that in every bubble in history, going back to tulib bulbs, the bottom was reached far below trend line.

Given that home prices are still way above trend line and that, we're only seeing the tip of the foreclosure tidal wave today. It's hard to see how we're near a bottom in terms of the fundamentals or the stocks (barring a huge government bailout). Excerpt from the Fortune article:

The homebuilders ETF is up 29% off its early January lows, while components Toll Brothers (NYSE:TOL), Lennar (LEN, Fortune 500) and Hovnanian (NYSE:HOV) are up 40%, 52% and 96%.

So after two and a half years of steep drops, have the homebuilding stocks finally seen a bottom? Some investors believe they may have - and that the recent bounce foretells sunnier days for an economy that has been besieged in recent months by recession talk.

"What took us into this malaise will be what takes us out," Bill Miller, portfolio manager for the Legg Mason Value Trust, wrote this week in a letter to the fund's shareholders. "Housing stocks peaked in the summer of 2005 and were the first group to start down. Now housing stocks are one of the few areas in the market that are up for the year."

Miller, whose fund lagged behind the S&P 500 by some 20 percentage points over the past two years after a 15-year run of beating the index, sees a possible replay of the early 1990s recession. Back then, a brief, mild contraction followed a housing boom and a banking industry crisis - the failure of the savings and loans. Many stocks tied to the financial sector fell to deeply depressed levels in that episode, and investors who bought those stocks near their lows raked in huge gains when the economy recovered.

Housing stocks "were among the best performing groups in 1991," Miller wrote, "and could repeat that this year."