Turnaround for Housing Stocks: Not Just Yet

Brokers gather around the post where they trade Fannie Mae prior to the opening bell at the New York Stock Exchange.

Home builders still can't get a break. On Monday, their shares jumped on news that Fannie Mae and Freddie Mac would be taken into conservatorship by the government. On Tuesday, declines set in again.

Indexes like the iShares Dow Jones Home Construction ETF (ITB) rose 9 percent from Friday's close but gave back most of those gains after analysts threw cold water on the sector's immediate prospects. Another ETF, the SPDR S&P Homebuilders (XHB), made a similar move.

Builders have suffered through the worst of the housing crisis but continue to face head winds in the form of high inventories of unsold homes, still slumping prices, and a slowing economy that has buyers (and their lenders) rethinking what is still most people's largest investment.

The next few months could be wobbly, and analysts disagree where builders are headed.

Yesterday's dip came care of Credit Suisse analyst Daniel Oppenheim, who cut builders to "marketweight" from "overweight" and lowered DR Horton, KB Home, Toll Brothers, and Pulte Homes to "neutral" from "overweight."

He noted that a survey of real estate agents showed lower buyer traffic in August due to still falling home prices, the uncertain economy, and difficulties in getting a mortgage.

Our Monthly Survey of Real Estate Agents indicated further declines in traffic in August (traffic index down to 25.9 in August from 27.4 in July) due to an inability to qualify for or find affordable mortgages, fears of falling home prices, and growing concerns about the weakening economy.

The problem is that the Fannie and Freddie bailout will help reduce mortgage rates but not enough to jump-start sales of all those unsold houses. Bankrate.com says that rates for average fixed 30-year mortgages fell from 6.25 percent last week to 5.79 percent today.

At the same time and despite the dismal housing environment, shares of home builders have bounced off annual lows set in mid-July. Stock prices of many of the larger builders have recovered a bit, up more than 40 percent from July lows, and many are in positive territory year to date (remember, the worst of the drop happened in late 2007).

That makes valuations less attractive, Credit Suisse notes, saying home-building stocks "are now trading at 1.3 times our adjusted book value estimates, which we believe is fair value." (Gloomy Credit Suisse analysts also cut the banking sector this week, noting the "current crisis looks worse than the early '90s.")

Not everybody is so down, however. Pali Research's Stephen East upgraded D. R. Horton, Lennar, and Toll Brothers to "buy" on the news over the weekend, saying, "We think this action removes a significant amount of uncertainty surrounding the housing market from the table."

He notes the government's actions could keep more homes out of foreclosure, which would help lower inventories of unsold homes, though he admits that "fundamental head winds still remain for the industry."

Goldman Sachs, which is neutral on the sector's prospects, says that while the Fannie/Freddie deal does reduce its near-term negative bias against home builders, it won't go bullish until buyer sentiment recovers. Goldman lays out two problems left to solve:

(1) reduced equity in homes of current homeowners (home buyers simply have less money to put down on their next house); and (2) reduced expectations for future home price appreciation - with home prices falling, many potential home buyers likely believe they can get a better deal in the future.

Home prices remain key to housing market stabilization A stabilization of home prices would greatly improve home affordability, in our opinion, since it addresses both lower equity values in existing homes and the expectation of home price appreciation.

That's the most important point: Wall Street won't get truly excited about builders until the pace of declines in home prices really starts to flatten out. So far, the pace of those declines only slowed. National prices were down 4.6 percent in the second quarter from a year ago, compared with 6.6 percent during the first, according to Global Insight. The research also says most of the extremely overvalued homes have seen prices fall back to fair ranges. The Case-Shiller home price index, which tracks metropolitan areas, fell 15.9 percent in June from a year ago, the largest drop on record.

Sales will have to recover, too. Pending home sales tracked by the National Association of Realtors fell more than expected in July. The measure, which leads existing home sales by about 45 days, is a hint that September sales will be down again.

Goldman does see very cheap deals right now for long-term investors. If you're willing to wait to take a profit, it rates D. R. Horton, MDC, and Toll as buys as housing market metrics hit all sorts of new lows—including, most notably, Goldman says, that "new home sales as a percentage of households are near 40-year lows."

Also, the balance sheets of home builders do look to be improving.

Capital positions at big names like Pulte Homes and Toll Brothers are improving. Toll's 18 percent debt to capital is at the lowest historic level, CEO Bob Toll said during the latest earnings announcement.

If they can stay in the black, there will be buying opportunities, too, as smaller players get squeezed by poorer credit options and falling asset values.

A study released today by Grant Thornton warns that more distress is coming in the next six months, with small and medium-sized builders facing the most risk—just the sort of thing that leads to big rounds of consolidation.

In the end, there will be winners among home builders when the dust settles, and they'll most likely be among the large, established names who got hurt the worst during the downturn. For now, wait for some clarity.