February 14 2008: 7:08 AM EST
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Homebuilders catch fire

A month-long rally has made housing stocks Wall Street's biggest winners in 2008, even as grim news rolls in on the real estate front. Can the good times last?

By Colin Barr, senior writer

International builders still booming
LaFarge CEO Bruno LaFont talks about how construction projects in other parts of the world continue at a record pace despite the U.S. housing slump.

NEW YORK (Fortune) -- The hard-charging homebuilding stocks are making believers of some investors.

Shares of the S&P Homebuilders Sector Spider (XHB), the exchange-traded fund that tracks the biggest publicly traded companies in the residential construction business, have risen 7% this year. That gain is noteworthy on its own, given the 7% decline in the S&P 500.

But what's even more dramatic is the huge rally that erupted in these stocks in the middle of last month, right before the Federal Reserve started cutting interest rates in a bid to stave off a possible recession. The homebuilders ETF is up 29% off its early January lows, while components Toll Brothers (TOL, Fortune 500), Lennar (LEN, Fortune 500) and Hovnanian (HOV, Fortune 500) 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."

The rise of the housing stocks is all the more remarkable given the declining health of the real estate market. The S&P/Case-Shiller 10-city index of house prices dropped 8.4% in November, marking its 11th straight monthly decline. Despite the sliding prices and a recent drop in interest rates, the market for houses remains glutted: The National Association of Realtors said last month that year-end inventory of existing homes for sale amounted to a supply of nearly 10 months at recent selling rates.

Meanwhile, the early returns on the 2008 winter sales season haven't been encouraging. Toll Brothers chief Bob Toll said earlier this month that based on January's traffic and deposit numbers, "we are not yet seeing much light at the end of the tunnel." And that was before the recent string of stories noting that more homeowners are walking away from their properties rather than try to pay off staggering debt. Toll Brothers even said in a recent regulatory filing that co-founder Bruce Toll's daughter, Wendy Topkis, and her husband have signaled their intent to back out of an agreement to buy a $2.5 million Florida condominium.

The apparent disconnect between stock prices and what's going on in the industry has some observers questioning the bottom call. The skeptics attribute the bounce to factors like short-covering - the process in which investors who had been betting against a stock buy the shares to cover, or close out the trade. Stocks in the homebuilders have been a favorite target of short-sellers, who are counting on falling house prices and a glut of houses for sale to depress demand for new houses and stretch the builders' finances.

"Hedge funds have been told to cut back on leverage," says Ron Muhlenkamp, who runs investment manager Muhlenkamp & Co. in Wexford, Pa., and oversees the Muhlenkamp (MUHLX) fund. Muhlenkamp, who owns shares of homebuilder NVR (NVR, Fortune 500), says the market's swoon in January - a month in which three-quarters of hedge funds lost money, according to one survey - could have accelerated the short-covering, driving homebuilder stocks up further.

Muhlenkamp isn't buying the homebuilders' stocks now for several reasons. First, he believes it won't be possible to get a good read on the 2008 spring selling season for another two months. Muhlenkamp adds that he suspects the rebound of the homebuilders is "more of an '09 story than an '08 story." That's partly because stocks that fall as far as the homebuilders have - Toll Brothers, for instance, has lost a third of its market value over the past year and is down 60% from its July 2005 peak - often need more than one tax-loss selling seasons to fully regain their footing, Muhlenkamp says. That suggests 2008 could bring further declines as investors look to offset other investment gains by selling homebuilder shares purchased at higher prices.

Others say the homebuilders have rallied before and may do so again, but they won't put in a sustained upswing till their businesses improve. Analyst Gary Gordon at Portales Partners in New York notes that over the past year, the homebuilders and related stocks have repeatedly rallied, only to give up those gains and touch new lows afterward. He believes the economy must start generating more high-paying jobs before the fundamentals will support higher prices for homebuilding stocks.

Gordon adds that he expects the government to try to take more action - going beyond the one-time stimulus program President Bush signed this week - to make housing more affordable and more accessible to less affluent buyers. An expanded guarantee program at the Federal Housing Administration, for instance, could significantly increase the pool of possible house buyers, he says. Sweeping action like that could set the group up for a more sustainable gain, Gordon says.

But other market watchers say the bounce in these stocks is already predicting a turn in the homebuilding business.

"Stocks are predictive of the industry about six to nine months ahead of time," says Justin Walters of Bespoke Investment Group in Harrison, N.Y. He says he is bullish on the sector, noting that house-price futures at the Chicago Mercantile Exchange have been forecasting a bottom in house prices in many U.S. markets toward the end of 2008.

Walters says the recent rally in the homebuilders stands out from past stock moves because volume has been so much heavier. He adds that this year's bounce in the homebuilders follows a pattern laid out in the collapse of the tech bubble back in 2000. Walters says the steep decline in these stocks - despite the recent rally, the XHB is down 48% from a year ago - has made the sector look attractive even if more declines are ahead for housing prices.

Perhaps the most bullish signal comes from the executive suites at homebuilders such as Hovnanian. In a recent post on the Bespoke Investment Group Web site, Walters and colleague Paul Hickey note that a few homebuilder insiders have started buying their own stock - a marked contrast to the heavy insider selling at marquee names such as Toll Brothers that marked the group's 2005 top.

"While some may argue that that homebuilders don't do a very good job building houses," Hickey and Walters write, "one thing they know how to do well is trade their own stocks." To top of page

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