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It's time to sell your home-builder stocks
Rising interest rates have slammed the door on the big gains this sector has enjoyed over the last four years. Earnings are still rising, but that will slow, too.
By Robert Walberg
For the past four years, few sectors have enjoyed more spectacular gains than housing. From their lows in early 2000, the stocks rode the historic drop in interest rates to gains of 500% or more. During this period, investors did well to buy on any dips. However, times are changing, and the strategy of buying weakness no longer looks wise.
Unless youve been pulling a Rip van Winkle over the past couple of months, you know that the interest-rate backdrop has turned from bullish to bearish. Rates, after dropping slowly and steadily for years, have turned higher -- with 30-year fixed mortgage rates climbing by nearly 1%. That might not seem like much, but its the biggest jump since mortgage rates climbed by 2.15% from October 1998 to May 2000. (Editor's note: See "5 stock sectors to avoid in 2004" to see Walberg's January predictions for the home-building market in 2004.)
With Fed Chairman Alan Greenspan promising to act swiftly to quell any rise in inflation, the Street expects rates to continue climbing throughout the year.
The future's so dark . . .
Just as the rise in rates a few years back drove stock prices in the housing sector sharply lower, the group has begun to roll over in response to the changing fundamental climate today. The average decline over the past few months is roughly 19%.
While the industry has suffered setbacks close to this magnitude during the historic four-year run, this is the first time that the majority of the stocks (eight out of 10) in the industry have dropped below long-term support.
In fact, the technical picture is the darkest it has been in a long time. Not only have most stocks taken out their 200-day moving averages, but recent recovery tries have stalled out at key resistance levels and the group is beginning to establish a pattern of lower highs and lower lows. Volume figures are also turning negative, as were beginning to see more activity on down days than up days. This weeks setback has left the stocks dangerously close to taking out their mid-May lows. Penetration of these floors would send a definitive signal that the groups best days are in the rearview mirror.
Earnings growth likely to slow
Now some of you might contend that the groups bullish earnings backdrop is more important than the deteriorating technical tone in determining future stock price direction. More often than not, I would agree with that viewpoint, but even the earnings picture is clouded -- and the technical tone reflects the growing uncertainty. Never forget that Sun Microsystems (SUNW, news, msgs) announced record earnings in mid-2000 just before plunging over the next three years from $60 to $3.
Related news and commentary on MSN Money
While stocks such as Pulte Homes (PHM, news, msgs) and The Ryland Group (RYL, news, msgs) are expected to experience earnings gains of 44% and 24% in fiscal year 2004, these growth rates are projected to slow dramatically to 11.8% and 8.9%, respectively. Admittedly, those are still decent growth numbers, but its the trend thats disturbing, especially considering that analysts tend to be overly optimistic or pessimistic at key turning points. If in fact the group is about to see a slowdown in activity, its highly likely that forward earnings estimates are too high.
Such fears were confirmed last week when Dominion Homes (DHOM, news, msgs) announced that expected home sales for the second quarter would be "significantly below" the year-ago quarter due to rising interest rates for its target market of first-time buyers. The company noted that gross unit sales for April and May were down 15% from the year-earlier months and that increases in cancellations affected net sales, which were down 35% from a year ago.
After the warning, analysts slashed their estimates for fiscal year 2004 from $4.10 to $3.35. Thats a downward adjustment of 18%. It also puts this years earnings estimate 15% below last years results. If it could happen to Dominion, it could happen to the others.
| Homebuilders fall through the floorboards | | Stock | 200-day M.A. | 50-day M.A. | May low | % off 52-wk hi | | Beazer Homes (BZH, news, msgs) | 97.61 | 98.61 | 89.15 | -16.7 | | Centex (CTX, news, msgs) | 48.78 | 48.20 | 43.31 | -22.8 | | D.R. Horton (DHI, news, msgs) | 28.06 | 29.56 | 24.63 | -24.3 | | Dominion Homes (DHOM, news, msgs) | 30.47 | 30.58 | 21.30 | -27.3 | | KB Home (KBH, news, msgs) | 68.17 | 68.86 | 60.27 | -24.8 | | Lennar (LEN, news, msgs) | 45.74 | 46.93 | 42.57 | -23.7 | | Pulte Home (PHM, news, msgs) | 45.68 | 50.04 | 44.75 | -12.9 | | The Ryland Group (RYL, news, msgs) | 81.28 | 78.86 | 71.23 | -20.9 | | Standard Pacific (SPF, news, msgs) | 48.05 | 51.65 | 44.66 | -24.7 | | Toll Bros. (TOL, news, msgs) | 38.85 | 40.56 | 36.29 | -19.2 |
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Lennar, Toll Bros. among the riskiest
Which stocks in the group are most vulnerable to additional price weakness? If rates continue to climb, its a safe bet that the entire group will underperform the overall market in the months to come. However, several stocks in the industry appear riskier than others. From a valuation standpoint, Lennar (LEN, news, msgs) and Toll Bros. (TOL, news, msgs) are at greatest risk, as they sport the highest price/earnings and price/sales multiples. Though the premium multiples are justified somewhat by higher margins, if the sector extends its decline, these stocks are likely to see their premiums compressed.
From a technical perspective, Dominion, Standard Pacific (SPF, news, msgs) and KB Home (KBH, news, msgs) look the most vulnerable to additional near- and intermediate-term price weakness, as each has taken out its 200-day moving average as well as its long-term trendline.
Ryland Group, Centex (CTX, news, msgs) and DR Horton (DHI, news, msgs) are close behind, as these stocks have fallen below their long-term moving averages in recent sessions and are establishing the very negative pattern of lower highs and lower lows. Investors should also note that all of these stocks are expected to experience a significant drop in the rate of earnings growth going forward.
Plenty of room to sink
How far can these stocks fall? As noted above, the group is already off its highs by an average of slightly more than 19%. However, such declines are small compared to the late 1998 to early 2000 decline that saw the average housing stock drop by more than 50%. In other words, if rates continue to climb and orders start to slow, these stocks have plenty of room left to fall.
A wave of consolidation could prove the groups salvation, but you cant count on a buyout to lift your share price -- especially since the companies are likely to wait for the slowdown to become more obvious before seriously considering growth through major acquisition.
Consequently, investors should not be tempted by the industrys relatively cheap valuations or by its recent history of rallying to new highs after every price dip. To the contrary, based on the deteriorating fundamental and technical backdrops, the time has come to sell any strength.
At the time of publication, Robert Walberg did not own or control shares of any of the equities mentioned in this column.
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