Get Ready to Short Homebuilders

Includes: BZH, DHI, PHM, XHB
by: Graham Summers

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 (NYSE: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 (NYSE: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 (NYSE:PHM) and Beazer (NYSE: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