Despair Finally Visiting the Doorsteps of the Homebuilders

By Dr. Duru written for One-Twenty

March 29, 2007

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Surprise, surprise. The post-Fed pop has already been frittered away. Fed Chairman Ben Bernanke even put a punctuation mark on this latest fade by clarifying that the Fed thinks the economy is just fine and it remains more concerned with inflation risks than an economic slowdown: "Because core inflation is above the levels most conducive to the achievement of sustainable growth and price stability, the Committee indicated in the statement following its recent meeting that its predominant policy concern remains the risk that inflation will fail to moderate as expected." In other words, a cut in interest rates is not even in the playbook. The post-Fed pop and subsequent fade is such an old and tired script, it is truly a wonder the market bothers anymore! I last wrote that I was wary of reading from this script because of my guess that the other tired script of end-of-quarter buying would likely support the bulls. Silly me. We still have two days left in the quarter, but the damage has been done. Big Ben did not bring a bouquet of bounty last week. It was the market getting the Fed all wrong as it so often does these days. The market saw flowers where there was really a bucket of cold water. But it is understandable. Everyone "knows" that economic growth is slowing and corporate profit growth is about to drop down from the paradise of double-digits, so the hopes (and prayers?) for interest rate cuts are just about the only thing that justifies the buying of stocks hand over fist. At least this persistent buying was a hallmark of the market from late last summer to late February.

Curiously, the homebuilder stocks have not benefited much from these fleeting hopes for interest rate cuts. On March 6, I declared these bad boys officially broken. And a week later, I wondered whether the writing was finally on the wall for the consumer given all the doubts being raised about the health of the mortgage industry and consumer debt levels in general. Events often develop quickly with these stocks, and now I am believing it is already time to look for opportunities amongst the despair. (See my disclaimer here). For example, Accredited Home Lenders (LEND) more than tripled from an all-time low of about $4.00 to over $12.50 in just a few days as the company scrambled to save itself from its sub-prime mess. (It is now hovering around $10). I remain skeptical of LEND, but this action indicates that some value is buried in the sub-prime mess - even if it rests at the mercy of the big financial brokers who have the financial wherewithal to play SuperBuyer. Indymac Bancorp (NDE) has been trying to insist all month that its business is above the sub-prime mess and that it's dealings in Alt-A loans are just fine. At least four different directors of NDE have been scooping up company stock in the past week in an effort to put money to mouth. I have already decided to play along beside them. Shorts all are over both these stocks - 40% of NDE's float as of March 12 and 46% of float as of February 12th for LEND - so we should not be surprised to see violent and abrupt moves in stocks like these. But what really has my interest now is the news last night that the Feds are investigating Beazer Homes (BZH) for potential mortgage fraud. The subsequent drop in the stock of as much as 10% tells me that despair is finally being priced into housing-related stocks. And this despair got me nibbling some more.

Until this year, the market had been buying bad news in homebuilder stocks. It was another example where the market gets so convinced of its own powers to discount the future that it begins to discount reality. The reality with the homebuilders? Earnings power has steadily eroded and assets in the form of land and options to buy land continue to get written off and devalued. Now, the sub-prime mess threatens to flood the market with more housing inventory from foreclosures and at the same time reduce the number of buyers because of a tightening of credit availability. A vicious double-whammy. It is only natural that as we question the lending practices in the sub-prime sector, we must also question the practices of all parties involved in these mortgage transactions. Apparently, the Charlotte Observer has been doing just that for the past several weeks regarding Beazer's activities in the Charlotte area (or click here for Part One of their investigavtive series). You can bet that newsdesks across the country are trying to jump on the bandwagon now to find similar nefarious tales laying at their doorsteps and crouching in their backyards. Expect more selling in the homebuilders as these stories trickle out. What was book value last summer is looking more and more like a lay-over to something lower. XHB, the homebuilder ETF, is still well above those 2006 lows, but many individual homebuilder stocks continue to suffer greatly. Two more stocks on my list have dropped below book value and some builders are now trading at steep discounts. The market is finally pricing in despair and looking ahead to worsening times, not better ones, for the homebuilders. Below is the latest from Yahoo!Finance on the price-to-book ratios (P/B) for several homebuilder stocks that I follow:

MHO: 0.62
BZH: 0.75
MTH: 0.87
WCI: 0.92
HOV: 0.94
TARR: 0.97
MDC: 1.03
PHM: 1.04
CTX: 1.04
DHI: 1.08
LEN: 1.23
TOL: 1.26
RYL: 1.27
KBH: 1.39
BHS: 2.29

The despair is getting so deep that not even a $22.00 bid for WCI from Icahn has put a floor on that stock. It is now trading below book value at $21.05!

But recall the NASDAQ bubble. After it popped in 2000 all sorts of cockroaches were revealed one after another in what seemed to be rapid succession. It took over two years for technology shares to reach a bottom. By that time, we pretty much assumed that the entire technology sector was a complete fraud. We have not yet reached those depths with the homebuilders and the bubble in housing, but we could get close as the two-year anniversary of 2005's housing top approaches. We may find more and more fraud in the mortgage industry. And even if it is somehow limited to the sub-prime sector, these growing scandals will increasingly call into question many elements of the consumer-led recovery from the shallow recession earlier this decade. The bears have been sounding the alarm bells for quite some time, and I suspect many bulls are getting nervous, if they are not already downright scared. I now think this is the time to stay alert for opportunity. I will not presume to have the market's "foresight" in discounting the bad news, but I have to think that we will soon look back at these prices and consider them "cheap" or "low." What I am much less confident about now is whether the rally from these prices will simply be the next phase in a sustained and persistent housing recession that eventually takes everything to lower lows. This is the difference between a "trading" opportunity versus an "investment" opportunity.

Be careful out there!

DR. DURU®, 2007