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Homebuilding Bears Out of Hibernation

NEW YORK -- Last January would have been a lousy time to short homebuilders. Even after the disappointment in June over the Federal Reserve's refusal to cut the Fed Funds Rate below 1%, homebuilders defied conventional wisdom that higher rates down the road would hurt sales. And then they defied gravity, rallying to new highs early in December. But now, a rising chorus of advisers is saying to avoid the homebuilders, while more aggressive traders are recommending short positions in the sector.

On Friday afternoon, Bryan Perry, editor of ChangeWave ProTrader sent out a bearish hotline recommending buying puts on the Philadelphia Housing Index (HGX) at a strike price of 355. The index of 21 companies (mostly builders) broke through support at 360 on Wednesday then bounced off of its low of 345. The index was up 65% through Dec. 3, when it hit its high of 371.52, but has since declined 4%. The reason for the steep decline on Thursday was news from Ryland (nyse: RYL - news - people ) that preliminary new orders for the fourth quarter are down 9% from the year-before level. New orders for 2003, however, were up 9% from 2002.

Perry says the "technical armor has cracked" on the builders and he says the oversold bounce provides a good opportunity to short a handful of big-name builders who may issue disappointing news in the weeks to come. "Lennar (nyse: LEN - news - people ), Centex (nyse: CTX - news - people ), DR Horton (nyse: DHI - news - people ) and Pulte (nyse: PHM - news - people ) seem to offer a clean three to five points of downside on this bounce," says Perry. "All their charts show pretty descript double top formations."

Indeed, the chart patterns for the homebuilders don't do much for Dan Sullivan, editor of The Chartist. Sullivan uses relative strength in his stock selection process and picked up a trio of homebuilders during the past two months. He got stopped out of Pulte Homes (nyse: PHM - news - people ) in December for a 13% loss, but still owns Lennar and Centex. Sullivan would sell on a break below $82.70 in Lennar, and $89.20 in Centex.

Steve Mais, an analyst with Sullivan, says there's no reason to ditch homebuilding stocks if you already own them, but no compelling reason for momentum investors to jump into them, as the group's relative strength is on the decline. "If you were making a list of new stocks to buy now, these homebuilders certainly wouldn't be on that list," says Mais.

Begging to differ is Jessica Chiaverini, a portfolio manager at the Prudent Speculator newsletter and Al Frank Asset Management. After the sector tumbled on Thursday, she and manager John Buckingham were busy adding to their positions in Centex, Lennar, Hovnanian (nyse: HOV - news - people ), KB Home (nyse: KB - news - people ), and DR Horton for their Al Frank mutual fund (nasdaq: VALUX - news - people ). Those stocks rebounded sharply on Friday. Chiaverini says the newsletter recommends Horton as a buy for new money, along with Beazer Homes (nyse: BZH - news - people ) and Standard Pacific (nyse: SPF - news - people ).

With the bond market all but assuming a rate hike will come by summer from the Fed, and with the ten-year Treasury yield occasionally spiking above 4.4%, it is quite likely that mortgage rates will continue to trend higher from their lows hit late last spring. Mike Norman, editor of the Economic Contrarian Update, usually holds against-the-grain opinions, although his latest comments seem to echo a growing consensus: the bull market for homebuilders is over. "I expect the housing sector to continue its slowdown and become a serious drag on the economy later in the year. At that point you will hear many of the pundits who declared that there was never any housing bubble start singing a different tune," says Norman. "It will hit both homebuilders and mortgage finance companies hard."

Chiaverini counters that mortgage rates are "not exactly taking off" and, while they're off their lows, they're still at very low levels. She also notes "broader demographic themes" that will support growing bottom lines for homebuilders, such as continued immigration into the United States, a shortage of land available for building, and the market share that big builders continue to steal from the "mom and pop" outfits. In addition, even while Ryland disappointed earlier in the week, Pulte announced a 31% increase in its fourth-quarter orders. The company trades at 7.7 times next year's earnings. Homebuilders in general trade for no more than ten times earnings--half the current forward price-to-earnings ratio of the S&P 500 of 20.