To Catch A Falling Knife

It has been interesting to listen to industry cheerleaders and financial analysts (who are for the most part -- can I use the "f" word? -- fundamentalists) explain the situation in the media. In the early stages of the slowdown that began in 2005, these cheerleaders proclaimed that slowing sales and building inventories were part of a healthy pause in a long-term uptrend. When sales kept falling, they opined it was a temporary leveling off from which demand would again reassert itself. And as inventories and sales accelerated in the opposite direction in mid-2006, they declared that it was part of a healthy correction but that prices would hold firm.

But then the unthinkable happened. For the first time in decades, home prices began to fall. By September 2006, median new- and used-home prices had dropped more than 10% across the nation, the biggest yearly drop since 1970. By early November, median new-home prices had also fallen 9.7% below 2005 levels and buyer contract cancellation rates had soared to 40%, even though it often meant walking away from deposits worth tens of thousands of dollars. It was the first time in history that cancellations spiked in the absence of a recession, according to Amy Crews Cutts, deputy chief economist at Freddie Mac.

Then in mid-November, while the National Association of Homebuilders housing market index was in the midst of a dead-cat bounce off lows not seen since 1991, came the news that October housing starts had again dropped, but this time by 14.6% to a six-year low while October building permits dropped 6.3%.

What did the analysts have to say? In a November 20th survey published by The Wall Street Journal, economists proudly declared the worst of the housing bust over by a margin of nearly 2-to-1. One well-known TV personality on CNBC even touted homebuilders as a buy, singling out DR Horton (DHI) as a particularly good candidate. It should come as no surprise to find out that he admitted on air to being a value investor who likes to buy when there is blood in the streets.

END OF THE TUNNEL OR AN ONCOMING TRAIN?
Not wanting to miss a potential opportunity, we decided it was high time to take another good look at homebuilders. After a year of significant declines, was the worst really over for this industry? Were there some good buying opportunities? To answer these questions, we explored the technicals and fundamentals for homebuilders, both as a group and individually. Here is what we found.

Figure 1: HOMEBUILDERS INDEX. Here you see the composite chart for the homebuilders over the last three years showing the bearish head and shoulders top pattern with most recent rising (bear flag) together with declining value (upper graph blue line) and plummeting relative value (blue line lower subgraph).

Figure 1 shows a chart of the building (residential-commercial) index made up of 26 homebuilders. From a technical perspective, 16 stocks (61.5%) were rated as buys, seven (26.9%) were holds, and only three (11.5%) were sells as of mid-November (as of mid-December, the ratio was little changed with 17 buys, seven holds, and two sells). As we can see, the building index resumed what appears to be an uptrend since bottoming with the rest of the market in mid-July. So from a short-term technical standpoint, stocks were demonstrating the series of higher lows and higher highs associated with a rally. The index also moved back above its 50-day moving average (MA) and was nearing its 200-day MA.

Figure 2: TOP 15 OF 26 HOMEBUILDERS ON THE WEEK ENDING NOVEMBER 17

Figure 2 shows the top 15 of 26 companies in the homebuilding index, rated from best to worst showing company, symbol, sales per share (SPS), and price/sales (P/S) ratios. Prices shown are as of the close of trading on November 17.

Relative value (blue line in the lower subgraph) is an indicator of long-term price appreciation potential and is superior to a simple comparison of price and value because it is computed from an analysis of projected price appreciation three years out, AAA corporate bond rates, and risk. Again, the idea is to purchase stocks with relative value ratings above 1.00 (value is higher than stock price).

Our next measure is growth rate (red line), which is the earnings growth rate and reflects a company's one- to three-year forecasted earnings outlook expressed in percentage per year. Growth rates are computed weekly from historical, current and forecasted earnings data and often foretell a stock's future price trend: If a stock's growth rate trend is upward, the stock's price will likely rise so it's best to purchase stocks where the growth rate is rising and is greater than the sum of current inflation and interest rates that as of November 17 equaled 7.07%.

Earnings per share (black line) represent the forward 12 months' earnings per share and are determined from a combination of recent earnings performance and traditional fiscal and/or calendar year earnings forecasts. It is desirable to find companies where earnings per share are positive and increasing. For a more detailed explanation of these terms, please refer to www.vectorvest.com/definitions.

As we see from Figure 1, the situation for homebuilders as a group has deteriorated significantly since July 2005. Both value and relative value have been pummeled, with the latter having dropped 36% from 1.40 to 0.90.

Figure 3, another set of metrics for the index in Figure 1, shows a similar picture for the growth rate, which has dropped from 18% in June 2006 to just 1% in November and to -1% by mid-December. Earnings per share also dropped from a peak of $10.89 in February 2006 to $4.61 in November and to $3.99 by mid-December. Further, there are no signs in a slowing of this decline, as some analysts would have you believe.

How have homebuilder stocks fared? First, we looked at the top-rated company in Figure 2. Desarrolladora Homex (HXM) (also known as Homex Development) trades on the NYSE. It is a large Mexican builder and developer that for the year ended December 31, 2005, sold 31,594 homes, and had 67 developments under construction in 26 cities located in 17 Mexican states, according to The Wall Street Journal (see Figure 4).

Figure 4: HOMEX DEVELOPMENT (HXM). On this chart you see a positive picture with growth in value and earnings. While the growth rate has flattened (not shown on chart) it is still 34%, down from a peak of 36% in October 2005.

Figure 5: MERITAGE HOMES (MTH). Here you see declining value, earnings (black line) and growth (red). Note the negative sloping downtrend line (magenta) showing the stock in a downtrend since peaking in July 2005.

Figure 6: THE BUILDING (RESIDENTIAL/COMMERCIAL) COMPOSITE INDEX OF 26 BUILDERS. Here you see the trendline analysis together with growth to PE (GPE).

Let's take one last look at the building (residential/commercial) index, but this time with trendlines and GPE (growth to price/earnings) in the lower subgraph of Figure 5. The higher the GPE, the more undervalued a stock is considered to be. With current long-term rates near 5.75%, a GPE of 0.33 or less means it's overvalued.

GPE rose from 2005 through mid-2006 even as the building index was falling, but in June after reaching a high of 3.22, GPE began to drop. By the third week in November 2006, it had declined to just 0.08, making the index extremely overvalued. The situation continued to worsen, with GPE hitting -0.07 in mid December.

Trendlines confirm a bearish long-term picture with blue trendlines showing the long-term uptrend that was broken in May at the next resistance point (horizontal blue line), while the magenta trendline shows overhead resistance in the current downtrend. The index was approaching overhead resistance in November.

DEADLY HABIT
There is a practice that technical analysts and traders call "catching a falling knife," usually associated with serious financial trauma. Fundamental investors, and value investors in particular, seem to have a tough time learning that just because the price of a stock has dropped to a more attractive valuation does not automatically make such stocks a good buy. They also ignore at their peril the overall downtrend in such stocks. Those who bought Enron and WorldCom learned this lesson the hard way, especially those who found them most attractive just before the stocks were delisted.

Looking at the charts, it is premature to say that the industry has recovered, especially considering that the pattern in Figure 1 has all the makings of a bear flag pattern, often a temporary lull before the next storm.

In addition, true market bottoms are often accompanied with capitulation volume spikes followed by volume increases as prices march higher. While there was an impressive spike for the building (residential/commercial) index's most recent bottom during the week of July 14, increasing volume as the index moves higher has yet to materialize. True to form for a bear flag, volume has instead steadily declined over the pattern.

As an industry, homebuilders are in no danger of disappearing, but some companies will as the economy cools. Until there is evidence that the worst is truly over, namely that increasing stock prices among homebuilders are accompanied by rising growth, GPE, and earnings rates, trying to pick a bottom could be detrimental to your financial (and emotional) health.

Looking at the larger picture, there is a more important question. What impact will the ongoing housing market meltdown have on the economy and markets in 2007-08?