Homebuilder Stock Bubble Popped By Reality

Nothing can pop a euphoria-based bubble faster than a harsh reality. If you don't believe it, just ask anyone who owned a homebuilding stock through September. The S&P 500 Homebuilding Index was the single-biggest loser among several dozen industries last month, tumbling 11%. That's in stark contrast to the runup from mid-July through the end of August, when the very same index gained over 60%. IN PICTURES: Digging Out Of Debt In 8 Steps

So, what happened to DR Horton Inc. (DHI), Pulte Homes Inc. (PHM) and the rest of these names? In simplest terms, I think the market took a little good news and turned that molehill into a mountain. Worse - and despite a steady improvement in the new home sales figure over the prior five months - that molehill is still a "glass half empty" proposition.

It's time for a homebuilder stock reality check.

Good News/Bad News
Yes, home prices increased for the sixth month in a row in July, according to the inexplicably tardy Case-Shiller index. Total new units sold increased for the fifth month in a row in August, up to a seasonally-adjusted 429,000. That's the good news, and the likely reason these stocks did so well beginning in the middle of the year.

The bad news is it's still not 2005 - new home sales are still 70% under the peak from four years ago. Making a tough problem even worse, previously-owned home sales fell 2.7% in August. The total inventory of homes for sale fell in August by 10.8% to 3.6 million.

But isn't that a good thing if existing houses are off the market and not competing with new contraction? On the surface, sure. In the bigger picture though, houses that are off the market right now may not be off the market indefinitely. Some analysts figure this so-called "shadow inventory" could total between 2 and 7 million units, each of which will crimp demand for new houses as they trickle into the market.

Read Between the Lines
To be fair, it's not that these stocks are a complete disaster. KB Home (KBH) fell short of its expected 58 cent loss for the quarter ending in August, by losing 87 cents per share. The loss was $1.00 less than the $1.87 per-share loss a year ago, and revenue beat expectations, which is encouraging. (For more on analyst expectations, be sure to read Analyst Forecasts Spell Disaster For Some Stocks.)

Lennar Corp. (LEN) also disappointed, losing 97 cents per share versus the expected 46 cent loss last quarter. Granted, the company took some pretty nasty write-down on existing inventory and land, but that's got nothing to do with the 35% dip in revenue.

The point is that it's hit and miss within the sector, which is better than the miss and miss situation about a year ago.

However, there is the looming end to the homebuyer $8000 tax credit, and I have to think last quarter's broad real estate improvement was the combination of an artificial stimulation, and very low comparables from a year earlier. One of those is going away soon, and consistently meeting low expectations isn't going to push your stock higher forever. When new and existing real estate sales start to exceed pre-September 2008 levels, then we can get excited.

Where There's Smoke ...
My biggest red flags, however, were provided by KB Home and Toll Brothers Inc (TOL) just a couple of days ago.

KB was offering a free 'Disney Dream Room' for any homebuyer that financed through its mortgage subsidiary. Toll Bothers offered an incentive of its own, in the form of rock-bottom mortgage rates and discounted upgrades for its selection of houses.

Considering Toll reported a respectable 3% increase in orders last quarter, there's been more than a little speculation that the dramatic move is a hint that demand is already drying up. As for the KB/Disney room promotion, I also see it as a tad gimmicky for something that's not a box of kids' cereal.

Bottom Line
If it seems like these builders (and others) are trying a little too hard to milk the market while they can, maybe it's because they are. Perhaps we should pay attention to KB's CEO Jeff Mezger's words from the Q3 report.

"The housing market overall remains in a transition where it will likely be some time before we see meaningful improvement in the economic conditions that are essential to our industry's future growth. While tentative indications are that some negative economic trends are slowing or leveling out to varying degrees in certain markets, the ongoing impact of and the potential for increased foreclosures and mortgage delinquencies, higher unemployment, tighter credit standards, and relatively weak consumer confidence make the timing and extent of a sustained rebound still uncertain."

For additional reading, check out Profit As Your Home's Price Changes and use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!