Several weeks ago on December 7th, I first wrote that the home builder stocks appeared to be close to a bottom, but that they weren’t quite out of the woods yet (based on the continued downtrend of the home builder ETF’s and the lack of insider buying).  There is also the lingering danger of news of a home builder bankruptcy at some point which could temporarily derail the entire industry.

With home builders rallying recently I thought it would be a good time to provide another update on the industry to get a feel for the proximity to a bottom.  I do think that the home builders continue to show signs of a bottom and the action in these names since I wrote that first report is one of increasingly healthy technical action.  Let’s have a look again at the home builders within the framework of the first update which looked at the characteristics of a bottom – rallying on bad news, insider buying, capitulation, broken downtrends.. anything else I may have missed?  Ah of course.. sentiment!  I think that’s a good start.

In early December I would have placed the odds of a home builder bottom at about 50/50, but with the Fed slashing rates and institutions clearly putting money to work in this space, I’ll up those odds to 70/30.  However, as you’ll see below, that does not mean it’s time to jump into the home builders right here.  I’m personally shorting them on a short term basis due to overbought conditions and signs of distribution.

1.  Rallying On Bad News

      When the worst scenarios are priced in, bottoming stocks begin rallying on bad news and we have certainly been seeing this in the home builders over the past several weeks.  At the top, analysts increasingly high expectations make it difficult for the company to beat leading to a sell off.  At the bottom, increasingly lowered expectations creates a situation where a stock rallies on any glimmer of hope.  That’s what  we’re beginning to see. 

– Meritage Homes (MTH) beat lowered expectations and rallied 25% yesterday just hours after the CEO said, "This has been the most difficult year we’ve experienced in homebuilding in more than 25 years, and we currently expect 2008 will also be challenging,"

– On Jan 24th Lennar (LEN) beat no expectations from analysts and despite posting big losses, the stock rose.  More dismal comments from another CEO: "As we look ahead to 2008, we are not expecting market conditions to improve, and perhaps might continue to decline in the near term. Nevertheless, the strength of our balance sheet, bolstered by the cash generated through our fourth quarter strategic moves, will keep us well positioned to weather these turbulent times. Additionally, our management focus on right-sizing our business, revising our product offering and reducing construction costs, together with our restated land positions that reflect current market conditions, will provide the springboard from which we will rebuild margins once the market does stabilize."

–  Ryland (RYL) reported Jan 23rd and beat estimates, rallying a bit before ending the day in the red.  The stock ran up big the day before so most likely profit taking after the morning run up.

It hasn’t been easy for all home builders to beat lowered expectations though..

–  On Jan 8th, KB Homes (KBH) posted a loss of 773 million which was much worse than expected and the stock closed down with heavy volume to a new 7 year low.
"As we enter 2008, we see no indication that markets are stabilizing," said KB’s chief executive, Jeff Mezger

 – Yesterday Centex (CTX) missed by a wide margin racking up nearly a billion dollars in losses with the write downs.  The stock finished down 10% with heavy volume.  Said CEO Timothy Eller, "Looking ahead we expect economic conditions to soften and foreclosures to increase and with that pressure on house prices may continue."

– Tonight Pulte Homes (PHM)is down another 5% after hours after losing 8% in the regular session following disappointing results.    "The challenging market conditions that plagued the homebuilding industry for the first nine months of 2007 worsened in the fourth quarter," Pulte’s president and chief executive, Richard J. Dugas Jr., said in a statement. "Levels of new and existing home inventory remain elevated, buyer demand for new homes continues to be weak, and mortgage availability is still a problem for many prospective homebuyers."

2. Insider Buying

In my last report I mentioned the large insider purchase by NVR CEO Dwight Schar, but no insider buying of that magnitude has been occurring in any of the other homebuilders yet.  Just a bit of insider buying at KB Homes (KBH) and Pulte Homes (PHM) recently.  More insider buying of home builder stocks can provide a bit more confidence that the bottom is in.  They aren’t going to be buying if they think their company might be in danger of bankruptcy and that is still a very real possibility.

According to Byron Douglass, an analyst at Credit Derivatives Research, the most exposed are Standard Pacific, Hovnanian, Beazer and Meritage. All are among the top 15 publicly listed US homebuilders.  He calculates the probability of bankruptcy at  79% for Standard  Pacific (SPF), 70% for Hovanian (HOV), 68% for Beazer Homes (BZH) and 66% for Meritage Homes (MTG).  Just yesterday, Tousa (TOUSA) was the largest home builder to declare bankruptcy.

Technicals

Perhaps the most important part of the bottom forming process is the technical picture which of course includes a surge in price and volume to the upside.  Specifically, I like to see capitulation (a take out of multi year lows followed by heavy buying and a close at the highs on a daily or weekly basis) and down trends broken.

3. Capitulation

I haven’t seen obvious capitulation across the home builders, but a few have shown capitulation.  Big capitulation isn’t necessary for a bottom, it’s just another clue to look for.  The important thing is that buy volume spikes on up days and sell volume diminishes on down down days which has been the general trend over the past several weeks.

4. Broken Down Trends

I mentioned in the last report that home builders weren’t quite out of the woods because the iShares Home Construction ETF (ITB) and the SPDR Homebuilders ETF (XHB) had yet to clear down trends, even though some of the individual builders had.  That is no longer the case as both ITB and XHB have cleared down trends with heavy volume.  Below is a look at the daily chart of XHB.  You can see it cleared the downtrend as homebuilders have soared 30 – 40% in just the past couple weeks.  However, as indicated by stochastics and MACD, they are now very much overbought in the short term and the big distribution today sets them up for digestion of recent gains.  Look for a pull back of 10 – 20% from here.

Sentiment

I didn’t discuss sentiment in my first report, but wanted to touch on it here.  On Jan 14th, DailyWealth wrote a very timely report on the negative sentiment in the housing industry titled "What the Worst Case Scenario for Housing Looks Like"  Sentiment is important because the masses are usually wrong.  In the article, Tom Dyson hammers home the point well. 

"Right now, everyone worries about housing. Sure, home prices could keep falling, and the pain could last for another few years. But you won’t make any money betting on that scenario, even if it does happen. Why? Because everyone’s already worried about it. And their fears are already priced into the market.

To give you an example, yesterday I read a research report from a Wall Street investment bank. The analysts performed a worst-case analysis on eight major U.S. homebuilder stocks.

These analysts assumed that the value of homebuilders’ raw undeveloped land had fallen 75%. Then they cropped new home sales prices by 40% and assumed inventory would sell at 75% slower rate than it’s selling for right now.

In other words, with the stroke of a keypad, they sent the homebuilding business back to the Middle Ages.

Here’s the interesting thing: Having made these awful assumptions, they calculated book value for the eight major homebuilding stocks. Book value is the capital invested in the business that belongs to shareholders. It’s what you have left when you add up all the assets and subtract all the liabilities.

The research found that, right now, these homebuilding stocks were trading around par with their worst-case scenario book values. Homebuilder stocks usually trade at a premium to book value. In other words, current homebuilder share prices are trading at a discount to the worst-case scenario."

I Stand By My #1 Homebuilder Play – NVR Inc (NVR)

I continue to believe that NVR will provide far greater returns than any of the other home builders.  In my last report I mentioned that "It (NVR) takes the top spot because of the big CEO insider buying, best technicals and the fact that the company has remained profitable in every quarter during this housing crash and is expected to remain so.  CEO Dwight Schar has also been through a meltdown before, nearly bankrupting NVR several years ago.  I’m sure he’s smart enough to learn from those mistakes.

On  Tuesday, amid hundreds of millions of losses from its competitors, NVR reported yet another profitable quarter.   David Zelman, president of Zelman and Associates, a research firm in New York, said NVR has had success in the down market by building to order and optioning most of its land rather buying it.  That strategy, he said, has "proven through the down cycle why it makes sense."  However, the company is also warning of continued tough times ahead.  "These sizable declines in new order units and prices will continue to have a significant negative impact on revenues and gross margins in the coming quarters."

On the technical front I mentioned on Dec 7th, "If I can get shares around 400, you can be sure I’ll be buying, but quite frankly I don’t think NVR sees those levels again.  Depending on what the overall market is doing, what the housing market is doing and the individual action in NVR I’d be looking at shares in the 450 – 500 range.  Note the potential double bottom base outlined in blue?  If in fact this is a valid double bottom base, 400 is the bottom and we can expect a run to 850 – 950 within the next year.

I am now further convinced that NVR is carving out a double bottom base with a long term bottom at 400, with a run to 850 likely by sometime later this year or early next year.  Let’s take another look at the technicals.  Just like all home builders though, it’s overbought in the short term and needs to digest recent gains.  Just as I thought it wouldn’t see 400 again, I doubt it will hit 450 following this recent surge.  A pull back to around 500 with light selling volume might offer a chance to scale into a long term position.

The Bottom Line

While much of the bad news is priced into the home builders and the Fed induced surge has led to increasingly healthy technicals, bankruptcy risk of some high profile names remains and builders are very much overbought at these levels.  If I’m a long term holder, I’m waiting for the Fed rate cut euphoria to wear off and scaling into a long term position on a pull back of 10 – 20% from current levels.  NVR continues to be my top play in this industry, but buying one of the home builder ETF’s (XHB or ITB) is probably the better option for the risk averse investor.

Disclaimer:  I am personally shorting the home builders in the short term to take advantage of overbought conditions.

This news isn’t all that surprising .  After all  bubbles create greed  and greed creates criminals , so it’s just a matter of time before the  prison parade begins.  Deja vu.

The FBI isn’t disclosing which companies are under investigation but undoubtedly some big, recognized names are in this group.  The investigation began in spring of 2007 and includes companies across the financial services industry, from mortgage lenders to investment banks that bundle home loans into securities sold to investors.

Chief of economic crimes unit Neil Power said, "We’re looking at the executives to see if they were committing insider trading."

Who’s in cuffs first? Angelo Mozilo of Countrywide?  Stanley O’Neal of Merrill Lynch? Let the wagers and blame game begin.

 Should be interesting to watch these guys testify  to Congress on Feb 7th.

Just thought I’d pass this along.  60 minutes takes a look at Stockton, California and how the subprime mess has affected homeowners there.  Yeah we’re all a bit tired of hearing about it but might be worth checking out.  It airs at 7PM EST/PST.  Here’s the teaser video.

Another mortgage company casualty after the bell today announced by Capital One (COF) during their earnings report.  In addition to cutting its earnings forecast from $7.15 to $5/share, COF announced that they would eliminate their Greenpoint mortgage unit (the 7th largest Alt A lender) and eliminate 1900 jobs.   According to the WSJ,   Capital One bought Greenpoint, which specialized in jumbo and Alt A loans less than a year ago in a 13.2 billion dollar deal.  With other large layoff announcements from Countrywide (CFC) and SunTrust  (STI) today alone and thousands more to come as other mortgage companies fold, you have to wonder just how much impact this will have on the economy from an employment perspective which has been largely ignored up to this point.  The housing boom was able to cushion the blow of many jobs being shipped overseas so the impact could be great.

Below is a reprint of an excellent article by Daily Wealth detailing the unraveling of the housing market.

What Caused the Housing Bust
By Porter Stansberry
August 18, 2007

Reprinted with permission by DailyWealth

Today, we take a break from our normal format to answer in detail a question regarding the current housing problem that must be on the minds of nearly all of our readers, as expressed by paid-up subscriber David Walker:

What is so unusual about the current times that so many smart people could be so catastrophically wrong?

Porter comment: What happened (and what is still happening) is simply leverage in reverse, or what people used to call a "run on the bank."

For nearly 10 years, as interest rates fell from 1995 to 2005, the mortgage and housing business boomed as more and more capital found its way into housing. With lower rates, more people could afford to buy houses. That was good. Unfortunately, it didn’t take long for some people to figure out that with rates so low, they could buy more than one. Or even nine or 10. As more money made its way into housing, prices for real estate went up – 20% a year for several years in some places. The higher prices created more equity… that could then be used as collateral for still more debt. This is what leads to a bubble.

Banks, hedge funds, and insurance companies were happy to fund the madness because they believed new "financial engineering" could take lower-quality home loans (like the kind with zero down payment) and transform these very risky loans, made at the top of the market, into AAA-rated securities. Let me go into some detail about how this worked.

Wall Street’s biggest banks (Goldman Sachs, Lehman Bros., Bear Stearns) would buy, say, $500 million worth of low-quality mortgages, underwritten by a mortgage broker, like NovaStar Financial. The individual mortgages – thousands of them at a time – were organized by type and geographic location into a new security, called a residential mortgage-backed security (RMBS).

Unlike a regular bond, whose coupon is paid by a single corporation and organized by maturity date, RMBS securities were organized into risk levels, or "tranches." Thousands of homeowners paid the interest and principal for each tranche. Rating agencies (like Moody’s) and other financial analysts, believed these large bundles of mortgages would be safer to own because the obligation was spread among thousands of separate borrowers and organized into different risk categories that, in theory, would protect the buyers. For example, the broker (like NovaStar) that originated the mortgages would be on the hook for any early defaults, which typically only occurred in fraudulently written mortgages. After that risk padding, the next 3%-5% of the defaults would be taken out of the "equity slice" of the RMBS.

The "equity slice" was the riskiest part of the RMBS. It was typically sold at a wide discount to the total value of the loans in this category, meaning that if defaults were less than expected, the buyer of this part of the package could make a capital gain in addition to a very high yield. Even if defaults were average, the buyer would still earn a nice yield.

Hedge funds loved this kind of security because the yield on it would cover the interest on the money the fund would borrow to buy it. Hedge funds could make double-digit capital gains annually, cost-free and risk-free… or so they thought. As long as home prices kept rising and interest rates kept falling, almost every RMBS was safe. Even if a buyer got into trouble, he could still sell his home for more than he paid or find a way to restructure the debt. On the way up, from 1995-2005, there were very few defaults. Everyone made money, which attracted still more money into the market.

After the equity tranche, typically one or two more risk levels offered higher yields at a lower-than-AAA rating. After those few, thin slices, the vast majority of the RMBS – usually 92% of the loan package – would be rated AAA. With an AAA rating, banks, brokerage firms, and insurance companies could own these mortgages – even the exotic mortgages with changing interest rates or no down payments. With the magic of financial engineering and by ordering the perceived risk, financial firms from all over the world could fill their balance sheets with higher-yielding mortgage debt that would pass muster with the regulators charged with making sure they held only the safest assets in reserve.

For a long time, this arrangement worked well for everyone. Wall Street’s banks made a fortune packaging these securities. They even added more layers of packaging – creating CDOs (collateralized debt obligation) and ABSs (asset-backed security) – which are like mutual funds that hold RMBS.

Buyers of these securities did well, too. Hedge funds made what looked like risk-free profits in the equity tranche for years and years.

Insurance companies, banks, and brokers were able to earn higher returns on assets by buying RMBS, CDOs, or ABSs instead of Treasury bonds or AAA-rated corporate debt. And because the collateral was considered AAA, financial institutions of all stripes were able to increase the size of their balance sheets by continuing to borrow against their RMBS inventory. This, in turn, supplied still more money to the mortgage market, which kept the mortgage brokers busy. Remember all the TV ads to refinance your mortgage and the teaser rate loans?

The cycle kept going – more mortgage securities, more leverage, more loans, more housing – until one day the marginal borrower blinked. We’ll never know whom or why… but somewhere out there, the "greater fool" failed to close on that next home or condo. Beginning in about the summer of 2005, the momentum began to slow… and then slowly… imperceptibly… it began to shift.

All the things the cycle had going for it from 1995 to 2005 began to turn the other way. Leverage, in reverse, is devastating.

The first sign of trouble was an unexpectedly high default rate in subprime mortgages. Beginning in early 2007, studies of 20-month-old subprime mortgages showed a default rate greater than 5%, much higher than expected. According to Countrywide Mortgage, the default rates on the riskiest loans made in 2005 and 2006 are expected to grow to as high as 20% – a new all-time record. The big jump in subprime defaults led to the first hedge-fund blowups, such as the May 2007 shutdown of Dillon Reed Capital Management, which lost $150 million in subprime investments in the first quarter of 2007.

Since Dillon Reed Capital, dozens of more funds have blown up as the "equity slice" in mortgage securities collapsed. Remember, these equity tranches were supposed to be the "speed bumps" that protected the rest of the buyers. With the safety net of the equity tranche removed, these huge securities will have to be downgraded by the rating agencies. For example, on July 10, Moody’s and Standard and Poor’s downgraded $12 billion of subprime-backed securities. On August 7, the same agencies warned that another $1 billion of "Alt-A" mortgage securities would also likely be downgraded.

Now… these downgrades and hedge-fund liquidations have hugely important consequences. Why? Because as hedge funds have to liquidate, they must sell their RMBSs, CDOs, and ABSs. This pushes prices for these securities down, which results in margin calls on other hedge funds that own the same troubled instruments. That, in turn, pushes them to sell, too.

Very quickly the "liquidity" – the amount of willing buyers for these types of mortgage-backed securities – disappeared. There are literally no bids for much of this paper. That’s why the subprime mortgage brokers – the Novastars and Fremonts – went out of business so quickly. Not only did they take a huge hit paying off the early defaults of their 2005 and 2006 mortgages, but the loans they held on their books were marked down, with no buyers available and their creditors demanding greater margin cover on their lines of credit… poof… The assets they owned were marked down, they couldn’t be readily sold, and they had no access to additional capital.

The failure of the subprime-mortgage structure – which started with higher-than-expected defaults, led to hedge fund wipeouts, and then to mortgage broker bankruptcies – might have been contained to only the subprime segment of the market. But… the risk spread because of the financial engineering.

With Wall Street wrapping together thousands of mortgages from different underwriters, it’s likely that hundreds of financial institutions around the world have traces of bad subprime and Alt-A mortgage debt on their books. Parts of these CDOs were rated AAA. Almost any financial institution could own them – especially hedge funds. Hedge fund investors quickly figured this out – and asked for their money back.

And so, in July, liquidity fears began to creep through the entire mortgage complex. Not because the mortgages themselves were all bad or even because the mortgage securities were all bad – but because all the market players knew a wave of selling, led by hedge funds, was on the way. Nobody wants to be the first buyer when they know thousands of sellers are lined up behind them.

The market "locked up." Nobody would buy mortgage bonds. And everyone needed to sell. Suddenly even Wall Street’s biggest banks – the very firms that created these mortgage securities – were suffering huge losses, as the bonds kept getting marked down as hedge funds and other leveraged speculators had to sell into a panicked market.

It’s a classic "run on the bank," except today the function of the traditional bank has been spread out among several institutions: mortgage brokers, Wall Street security firms, hedge-fund investors, and banks. The real problem is that the long-dated liabilities (a 30-year mortgage) were matched not by reliable depositors, but by fly-by-night hedge funds, which were themselves highly leveraged and subject to redemptions.

That’s why even as the top executives in these firms believed their mortgages were safe and sound, they can’t get the funding they need to hold onto them through the crisis. As Keynes predicted, the lives of every higher-leveraged financial institution is precarious: " The market can be irrational longer than you can remain solvent."

The hedge funds have no solution. Redemptions will force them to sell. They’ll continue to pressure the market, resulting in huge losses. Hundreds of funds will likely be liquidated.

Wall Street’s investment firms, if they can find additional capital to meet margin calls, might weather the storm… depending on how far it spreads. We saw a move in this direction this week when Goldman announced $3 billion in additional funding for its big hedge funds.

For most mortgage brokers, the party is over – goodnight. Something like 90% of them will be out of business by the end of the year.

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UPDATE:

I received these comments from the CFO of a local homebuilder (pacific northwest) regarding the above article: