Housing stocks: Don't wade in yet
The sector has stabilized after a brutal selloff, but another leg down may be coming, soon.
By Alexandra Twin, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- Since peaking last summer, shares of the nation's biggest homebuilders have tumbled some 60 percent, and the sector's probably going to get worse before it gets better, industry analysts say.

No kidding, you might say. Homebuilder confidence is at a 15-year low, six major companies have sounded the alarm on the housing sector in the last month and a report Tuesday showed housing starts fell to a three-year low.


"If homebuilding stocks have a strong correlation to housing starts, you've got to ask, how much worse does it get?" said Jack Ablin, chief investment officer at Harris Private Bank.

Yet since falling to 52-week lows this summer, many of the homebuilding stocks have been rising of late, with investors wondering if they've perhaps bottomed out. In fact, the homebuilders have kept ahead of the S&P 500 index in the third quarter, especially this month.

Widely respected managers such as Legg Mason Value Trust manager Bill Miller has said he's a buyer of the sector, as he thinks that when the housing market recovers, the stocks will too.

But Miller also admitted in his second-quarter note to shareholders that he had been too early to call the bottom and as a result, had gotten burned.

Miller can perhaps afford to misjudge the bottom on this sector, as he probably has a longer term horizon than most investors and more flexibility to take risks. But for many investors, this is a sector to keep avoiding.

"We don't think housing stocks have bottomed," said Peter Brodie, director of investments at Bryn Mawr Trust Wealth Management. "There's a question of how severe the slowdown in the housing market will be in certain parts of the country, but we'd want to see some stabilization before considering the sector."

Homebuilder stocks don't traditionally recover until about three months before the housing market hits bottom and starts to recover, which is probably at least a year away, said Gregory Gieber, an analyst at A.G. Edwards who covers the sector.

"Right now we have a record overhang in the industry and to eliminate that, construction activity has to slow and prices have to come down," he said. Although some evidence suggests home prices are dropping from the highs of the recent boom, on a national level the slide has been small, he said.

"It's no different than Macy's having way too many light sweaters going into November. We're not going to get a rebound in early '07. We may not see an improvement until '08," he said, referring to the housing market and homebuilder stocks.

More downside?

Homebuilding stocks had risen steadily since 2001, but the pace picked up in 2004 and the first half of 2005, as investors took advantage of low mortgage rates and strong growth in the economy that helped spur record housing starts, and home sales, last year.

But the rally for the sector peaked in July 2005, and housing stocks tanked in last year's third quarter. As the broader stock market recovered in the fourth quarter, so did housing stocks.

By January 2006, the stocks were within shouting distance of the highs from the previous summer. Yet that proved unsustainable, and the stocks sold off until recently, when they again started to move up.

Year-to-date, the housing sector is down about 18 percent - as measured by the Philadelphia Housing sector (Charts) index - versus a gain of 5.7 percent for the S&P 500 (Charts) index. Since peaking in summer 2005, the sector is down 63 percent.

The drop reflects the cooling housing market amid higher mortgage rates and the pressure on consumer spending from rising inflation. But considering that the homebuilding stocks are up more than 250 percent over the last five years, according to Baseline figures, stock declines so far have been fairly small.

Also making more selling more likely is the fact that housing stocks have been swept into the recent rally on Wall Street that pushed the Dow industrials to within about 160 points from their record high.

In the third quarter, the broad homebuilding sector is currently up 4 percent versus a 3 percent gain for the S&P 500 index. In September, homebuilders are up 5 percent compared to the S&P 500's 1 percent gain.

The broader market may see its traditional year-end rally again this year. But housing stocks aren't likely to enjoy that same recovery. For them, the recent runup may have been the last gasp for a while.

Biding time

The stocks could just gyrate in a range for a while, moving in tune with each subsequent housing market report and missive from the Federal Reserve, said Carl Reichardt, an analyst who covers the sector for Wachovia Securities.

Going forward, news on the housing market "is going to continue to be bad," Reichardt said. "But the issue is whether the news is 'things are bad and getting worse,' or 'things are still bad, but getting a little better'."

Gieber at A.G. Edwards is concerned that many builders will have to take charges in early 2007 to compensate for a land buying frenzy in 2004 and 2005 that is no longer in tune with the demand.

Meanwhile, Wachovia's Reichardt said that while comparisons on orders will get a little better next year, profit margins are going to keep getting squeezed, and that will pressure the stocks.

What could help provide a floor for housing stocks next year is the Fed, Reichardt added, should the central bank decide to hold interest rates steady, or eventually cut them. The sector could also benefit as the bottom in the housing market approaches, as in ' things aren't as bad as last time, so therefore they're better.'

The stock he likes best is Toll Brothers (Charts), which he has a "buy" rating on. He said that the company, like many in the luxury market, was among the first to get hit by the slowdown and could be among the first to recover.

Other stocks in the sector include Lennar (Charts), KB Home (Charts), Beazer Homes (Charts), Hovnanian Enterprises (Charts), Centex (Charts), MDC Holdings (Charts) and Pulte (Charts).

Among individual stocks, the only one Gieber has a "buy" on is D.R. Horton (Charts), which he says he likes partly because they haven't been buying back a lot of stock like competitors, which means they'll have more cash available when the housing market comes back.

He also said that they have a "Wal-Mart (Charts)-like strategy" of competition that will probably serve them well in a rough market, by going into areas and pushing smaller competitors out.

"In this kind of environment," he said, "you need a company that will do that."

Housing starts hit 3-year low

Builders riding out stocks' slide

Homebuilder confidence shaken Top of page

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Gieber doesn't own shares of D.R. Horton and A.G. Edwards does not have a relationship with the company; Reichardt does not own shares of Toll Brothers; his firm, Wachovia may seek to do business with Toll Brothers in the next three months.