Something has Changed
Last month, I posed the question “Is it time to short the home builders?” My conclusion at the time was pretty much a “wait and see”. Circumstances have changed. I believe the builders are now short candidates.
Beware of politicians trying to fix the housing market (the Johnson-Crapo GSE reform bill actually failed last year)
Cartoon by Glenn Foden
There is only one upside risk to shorting the builders – the government. In almost two years, Yellen has demonstrated that she is the timid little old lady who lacks the delusions of grandeur that possessed Bernanke. The White House and Capitol Hill are going to be too busy with the elections to do anything radical. Therefore, while the builders may once again be bailed out, it will likely happen in the future and after short positions are already covered.
The real estate market typically moves slowly, by a few percent a year. Once in a while, it may come to an abrupt stop. Volcker did it in 1981 with his rate hikes. The S&L crisis did it in 1989. More recently, the sub-prime bubble shut down the market in 2007. It may happen again now. Unless one is positioned already, there may be little time to initiate positions.
Excellent tell-tale signs are in this report by Diana Olick of CNBC. Here is the best part, a quote from an interview with the CEO of Chase Mortgage:
“FHA requirements are down to a 520 FICO (credit score) and you only have to put 3.5 percent down; that’s sub-prime lending, and we’re not in the sub-prime lending business,” said Kevin Watters, CEO of Chase Mortgage Banking.”
The evolution of affordable housing, endpoint.
Carto(o)n by John S. Pritchett
It is not just the FHA, the other agencies are not that different. I have long opined that the government is evil, and that it owns the mortgage business. Instead of forcing loans upon those who cannot afford them, the agencies should be tearing up their loan applications, advise them to practice austerity, save up some money, and clean up their household balance sheets, rather than think about buying a house on margin. Do you have any idea how many payments you have to skip to “earn” a 520 FICO score?
Existing Home Sales
Another tell-tale sign is the recent NAR existing home sales data. The numbers are meaningless. What we see is that the market is starting to stall. It has happened before – no buyers, no sellers. The profit model of the builders is counting on more sales at higher prices. A stalling market is not an option for builder profitability. New home sales are bound to follow existing home sales. Builders’ margins should soon be under severe pressure.
Lennar reported its earnings on Monday. Lennar has the most opportunistic style of management and for that, I personally do not include LEN as a short candidate. While they have beat estimates handily, the underlying reasons were all unrelated to home building. The industry has enjoyed a year of easy comps, expanding sales and price appreciation. LEN seems to be indicating that the easy money is about to end.
Dovish Federal Reserve
The FOMC did not raise rates, even though it would have been just symbolic, or a show of blind faith in this so called recovery. Any form of QE4 would only serve as a confirmation of the dire condition that not only the US, but the global economy is in.
At the moment, the market is optimistic about the builders and is rewarding them with a price premium. If this optimism reverses to pessimism, then the sector will trade at a discount. This would be the smallest expected reward, assuming no change in fundamentals.
Home building is a miserable business. First you borrow to buy land, then borrow some more to develop land, then more to build, while paying out exorbitant executive compensation all along. Years later, you finally sell the finished product, maybe for a profit, maybe at a loss. Builders have been buying more land at much higher prices in hope for a continuation of optimal conditions. Lucrative margins can turn into large losses, much like 2006-07. That is the payday that I am hoping for.
In conclusion, the risk/reward ratio appears to highly favor shorting the builders. Unless the Yellen Fed comes up with a big surprise, I think shorting rallies will be the way to go. As for particular stocks, I am not sure if it really matters, just short a basket. Finally, as a reminder, these rants are for the purpose of organizing my own thoughts and should not be confused with investment advice.
Charts by: St. Louis Fed, stockcharts