Crack in housing foundation?

Putle Homes and MDC holdings both reported what could be the first crack in the housing bull market. Prices in Nevada have softened considerably, after being one of the natioin's hottest markets. Pulte has even begun to cut prices to try and move inventory. In the end, even with all of the sappy Fannie Mae commercials about the dreams of homeownership, housing is just another cyclical business. When capacity is over expanded inventories bloat and production is slowed/stopped until inventory is worked off. This phenomena can be seen with the automakers who are almost giving cars away right not to get rid of inventory.

The major question now is whether this is the first shot across the cyclical bow. Other hot markets like Florida, Maryland and California could be the next to show signs of strain. If I were the class, I would monitor put activity in Toll Brothers for signs of smart money having data that their markets are weakening. Pulte puts traded over 10,000 contracts the day before the announced disappointment....after averaging only 700 contracts prior. Remember, P/E ratios are usually very low at cyclical peaks for cyclical industries.

As a member of the current class, I'd first like to thank any alumni for posting threads in an effort to help us. This current info on the housing market is very concerning to me and I will bring it to the classes attention right away. I have 2 questions for you. What exactly is smart money? Do you feel that the housing market is overvalued at this point in time? Please keep us informed of any new information brought to your attention.

First - the point of my post is neither to be alarmist nor to offer advice. Rather, it is to stimulate conversation and debate. Opinions are usually divided on questions like "are housing stocks expensive", and when they are not it is typically smart to run the other way as fast as one can! One concept that may be "new" to class members is the idea that cyclical companies often look cheapest when their earnings are peaking. I have no idea whether housing stocks' earnings are peaking and I am by no means an expert on the industry. However, I think it is easy for investors to become complacent owning a stock just because it is "cheap".

As for smart money, I was referencing those who may be "in the know". It is hard to believe that the tremendous spike in volume for Pulte puts just before a very disappointing announcement was just a coincidence. Those who get good information before the market does often go to the options market because of the leverage it provides.

Ultimately, my opinion on the housing market is only a spec in the world that makes the markets go. I don't think getting into my opinions is healthy unless we could find someone to take the other side, so as to prevent undo influence (anyone can make their argument sound compelling when not challenged!). However, I'll give you an idea of where my opinion lies- my wife and I rent.

I'll be happy to pass along any info I get. Today, Toll Brother's CEO rebutted what Pulte said about Las Vegas and stated that demand is still strong and that their earings are on track.

I do realize that you are only trying to stimulate debate, and I also realize the underlying objective of imp (which provides the forum we are talking on now) is to learn and question and converse. However, information like that is a little alarming. Especially when it is quite possible that Toll Bros. and Hovnanian's earnings could have already peaked. I am not in charge of watching these two stocks so I want to make sure my peers are up to date with the current situation.

My point of view on the housing industry: The consumer cyclical sector's EPS as a whole is reaching its highest EPS in 10 years, 1.62, its high was 1.69 in 2000. It seems evident that the extrodinary growth of housing companies' EPS is directly correlated with the consumer cyclical sector's EPS growth. So how long can the housing industry keep up its extrodinary growth? I don't know, but with housing prices increasing at such high rates it almost seems inevidable that there will be some sort of correction if not a crash with in the housing market. I do believe stock prices are high and future earnings growth will be declining. I don't know exactly when, but I know I feel like its time to "run the other way as fast as we can."

As far as housing stocks being expensive. I'm not really sure if you want to talk about housing stocks being expensive right now, or if you can consider housing stocks expensive when P/E's are low. Please clarify alittle bit. Thanks

Ryan Shontz

P.S. It would be nice to know who I am talking to just out of curiosity. When graduated? Where do you work? If you have any questions about the current class please feel free to ask

I graduated in 1997 and I am also on the advisory board. I am a partner with TEAM Financial, a Registered Investment Advisor in Harrisburg. As for the relative valuation of housing stocks, I believe the key is what view one has regarding whether the housing "story" is cyclical or secular.

One of the secular arguments I hear is that demographics and continued low interest rate and inflation environment will support a continued long term bull market in residential real estate. One of the cyclical arguments is that interest rates have been held artificially low and that government reported inflation #'s are inaccurately low, and that once structural imbalances readjust the housing market will go through a cyclical downswing.

Valuation come is to the picture in the following way - if one believes that earnings are at a cyclical peak, then the stocks are not cheap. The stocks could be trading at a large multiple of "normalized" earings, which are a mid cycle measure. However, if one believes in the secular growth story, then the stocks are amazingly cheap because earnings will continue to grow at a rate well above the multiple currently being paid(mid to high single digit).

The outcome is likely to be binary in my opinion - meaning they will either be big winners or big losers. There are extremely smart managers with tremendous track records on both sides of the issue....a tremendous battle ground.

If I were to make an argument for one side, I do believe that interest rates have been held artificially low. The fact that interest rates have been held so low as a stimulation package leads me to believe that when they start to rise, the stimulation will decline along with many cyclical markets. To me it makes sense, but I know there are many other components that are important as well. Just looking over our current holdings in the industry leads me to believe that their stock prices have peaked and will begin to decline along with future earnings growth.

I am not sure about the inflation data, only time will tell if the #s reported will have been acurate or not. So with the little research I have done on the subject I would argue that as a whole, earnings in the residential housing market are near its cyclical peak. How close I really am not sure. Yahoo.com's analyst tend to argue that forward P/E ratios for several key housing industry stocks will continue to drop, meaning that earnings have not yet peaked and won't for atleast one more year. But like you said there is a tremendous battle ground.

I look at it like this. If I were going to enter the stock market for the first time. I would follow my top-down approach to do sector and industry analysis. And then later after I have decided on the "best" industries to invest in. I do not believe that the housing industry as a whole would be near the top of my list. Basically someone that decides to invest in the housing market now...has missed the boat. Earnings have grown so furiously that it seems impossible to do so for a long period of time (starting from right now). My opinion is that housing stocks are not cheap right now. I personally, being the more risk-averse investor that I am, would be happy to leave it up to the invtors that would rather take the chance of big losses to get the big gain. Ultimately I would rather find an investment I am more confident will bring me returns.

I do though always keep an open mind and can understand the secular arguement. I would have to see some data proving it because everything I have seen leads me to believe in the cyclical arguement.

http://www.pimco.com/LeftNav/Late+Breaking...IO_Oct_2004.htm

That is a link to Bill Gross's monthly commentary - he controls a huge amount of capital in the bond market and has a great track record. For anyone interested, his monthly commentary is a must read. This months deals with inflation and addresses issues I have personally worked on for 2+ years. I actually think that Mr. Gross is missing a critical point in his commentary - the use of rental equivalents in the CPI....and hence I think inflation is even higher than what Mr. Gross suggests....which is higher than what the government says!

As for top down vs bottom up, I tend to agree with you. I personally believe it is far more important to figure out secular themes that have the wind at their back. Owning the worst company with the wind at its back often outperforms the best company in a sector that is in secular decline. This is a question that is hotly debated by many within the profession, with many distinguished people lining up on both sides. Personally, I attempt to identify secular themes and then try to identify companies that are trading at a significant discount to potential peak earnings.

I would argue that housing has had a secular bull market....but that it started when interest rates were at 18% in 1981. I don't know when it will end, or whether it already has, but I am confident that we are closer to the end than the beginning. Secular lows are typically accompanied by apathy and disgust - far from what we see in residential housing.

I totally see your arguement for secular and it does make sense. Do you think that the housing secular bull market is correlated with population growth. Or maybe there are more people at the age in which they can afford to purchase homes than ever before. It would be interesting to see data showing population trends, ages, income, # of homeowners, etc. in the U.S. since the early 80s. It seems quite possible that the baby boomers could have been a significant impact on the growth of the residential housing market.

I would really have to research more before I had a strong opinion on either side. But I feel that depending on the location, the housing market could have been considered secular bull mkt or cyclical? Over-developed areas vs. newly emerging locations. However as a whole, I still feel, from what I have been exposed to, that the housing market is cyclical. It just makes sense that when the economy is growing people aren't affraid to make a big purchase. When they have money and when interest rates are low, they can afford mortgages and are more willing to take on those mortgages. And in turn when the economy slows so does big spending.

However, since the early 80s-2000, you can argue that there has been a secular bull market for the entire stock market, especially the 90s. Everyone had so much confidence and everything was going great, that interest rates didn't matter. So, has the housing market had a secular bull market or perhaps a speculative bubble.

Why is a secular low accompanied by apathy and disgust?

I agree with what you said about identifying secular themes with the wind at their back. If you can identify a theme now, before it is considered secular, and then do a thorough bottom up approach to analyze the company and value of the stock, I don't see what else could be a better way to invest.

As far as Bill Gross's commentary, I will take a look at it tomorrow or wed. Too much homework at the moment.

Which leads me to a question I have, which is totally off the subject. Where is a good place to get data on industry averages and industry ratios. (eps growth, financial ratios, expected growth rates, etc.) Right now I have found info through reuters but I was wondering if you or anyone that reads this knows of any other websites to use.

Just a note to the class. Dont get entirely caught up on focusing on the industry itself. This is a key part of the success of a company but dont ignore the fundamentals of the industry or the company itself for sake of trend analysis. A well rounded valuation considers all aspects of a company, its industry, and its life cycle.
I'm not sure there is enough analysis and study devoted during the class and on an individual basis to look for market timing, but if there is a general consensus that the housing industry is looking to weaken and a beleif of a peak in market value for the stock has been reached, consider selling. Dont be afraid to present this to the class on the grounds that its been a stock that has been held for a while.
From what I remember there was a general investment view of picking companies that were undervalued when comparing an IV to their market price. If you beleive a stock has reached or exceeded its value then present it as a recomendation on that and other factors from industry that you beleive it has peaked and it is time to get out. On the oposite end of this, if you beleive the company has a larger long term growth potential then present it that way and recomend to hold.

The are of secular trends and cylces is an area in which I have done a lot of work and is at the core of how I have helped build my business and how we invest our clients' money. Ultimately, valuation determines what stage something is in. Secular bull and bear markets (in all asset classes) have cyclical moves within the secular trends. For example, the US stock market enjoyed a secular bull market for much of the 80's and 90's, but it also included some cyclical "corrections" like the crash of 1987, recession of 1990-91, and the bond market debacle of 1994. The secular bear market from 1966-1982 (in which the market lost value in real terms) included several cyclical bull market rallies of 25%+ of 12+months.

My personal opinion is that housing has been in a secular bull market since the early 1980's and that it has "enjoyed" what usually happens at the end of secular bull markets - a speculative blowoff to the upside. The secular bull has been enabled by a secular decline in interest rates (bull in bonds), favorable demographic trends, and massive credit creation from our central bank.

Secular lows are accompanied by apathy and disgust because the bear market devours the psyche of investos in that asset class. 1981 included various famous magazine covers from leading business periodicals - inclusing "The Death of Equities". This occured at a bear market low - quite different than 1999-2000 when owning stocks became so mainstream that several network shows were created soley around wall street. Currently, we see Donald Trump as an icon and too many house fix me upper shows to count.....sign of a top or bottom? This type of analysis is as much art as it is science, but it can be very effective.

Yahoo Finance is a great free site for industry and company info - I use it all the time.

I agree that the class is not structured, nor could likely execute, market timing as it is commonly understood (basically trading). However, there are other forms of market timing that are longer term in nature and are true to what Benjamin Graham pioneered as securities analysis.

In 1969, Warren Buffet returned his investors money because he could not find anything to invest in. Save one company, he placed all of his personal money into intermediate municipal bonds. Five years later and after the broad market averages had declined by 75% in real terms, Mr. Buffet reinvested his wealth in equities.....because they had become cheap enough to create the opportunity for excellent returns.

Obviously, Mr. Buffet is a special case, but investing in expensive securities en masse is comparable to buying an expired lottery ticket - you've lost before you even begin.

http://futures.tradingcharts.com/chart/LU/B4

That links to a chart of lumber futures. As one can see by looking at the chart, lumber prices have declined 20% + since peaking in September. This could be a leading indicator for housing and could be an important piece of data when taken within context of the broad mosaic of recent industry reports.

This morning Washington Mutual (WM) reported that adjustable rate mortgages accounted for 67% of its home-loan volume, up from 55% in the second quarter of 2004 and 27% a year ago.

This is very disconcerting considering the flattening in the yield curve of late and with long term rates near all time lows. Why would a home buyer accept a high level of interest rate risk with long term rates at all time lows and short term rates heading higher? Perhaps buyers are trying to buy too much home as prices outstrip incomes. Yet another piece of the mosaic?

"....Sales of new homes plunged 12 percent last month, the biggest drop since a 23.8 percent fall in January 1994, to a seasonally adjusted annual rate of 1.125 million units. But industry analysts played its significance down, saying applications for new mortgages still were at healthy levels.

"I would not view this report as the beginning of a significant downturn," David Berson, chief economist for mortgage financing giant Fannie Mae in Washington..."

Any thoughts?


Link to the release:
http://story.news.yahoo.com/news?tmpl=stor...s_nm/economy_dc

Wall Street has proven to me someting over the years - most "analysts" are absolutely horrible at identifying inflection points. Of course, if identifying them were easy then we would all be Billionaires! However, I wouldn't look to most Wall Street strategists for advice as to whether a meaningful turning point has been reached (just my opinion of course).

ECRI is a private business cycle research firm that does tremendous research on leading indicators - housing prices being one of them. ECRI was one of only a few people/organizations who correctly forecasted the 2001 recession and they have also nailed the "jobless" recovery - where job creation has dramatically lagged the average of prior recoveries.

ECRI's leading indicator for housing prices suggests that things are in fact cooling off - but that a decline is not in the near future. Housing stocks have continued to do very well, as profits have come in great on the whole and multiples have expanded a bit.

"Inflection points" are rarely that in the financial markets - but rather processes. Bottoms and tops are often achieved over a period of months not days. Would a slowing in housing prices impact housing stocks? I don't know - and anyone who does please let me know! My guess is that they could come under pressure while the news becomes more well known, but that a cooling environment could lead to industry consolidation....something that is not unusual for such a fragmented industry....and also frequently accompanies speculative blow off tops.