Home Builders, Part 2
October 18, 2008
A lot has happened in the markets since we last looked at the home builder stocks in September.  The S&P500 has dropped over 20% during the month, and our MG631 Residential Construction Index (RCI) has dropped by slightly more.  Nonetheless, I wanted to revisit the group, and take a look at the best performers. 
RCI Update
First, here is the same chart as before, only updated:
Chart 1
MG631 vs. S&P 500

As we continue the journey of the homebuilders, we see that they were victims of the sell-off of the past 4 weeks.  No group was spared in this route.
There are a couple of constructive things to notice about this chart, however.  Firstly, the Index has oscillated up and down in a pretty consistent range.  This is probably a sign of a bottoming process.  Compare the movement against the red S&P500 chart, which has gone pretty much straight down.
Secondly, the bottom, green line is the relative strength of the RCI to the market.  It is still crawling above the yellow trendline, despite the harsh sell-off recently.  I'll be watching the re-test of the yellow line for signs of a rebound.  One of two things will happen:
1.  The RCI will turn up on or before it hits the yellow support.  This means that Home Builders are increasing in relative strength to the market, a very bullish sign
2.  The RCI will continue down through the support.  This is bearish, and signals that the home builders are falling back out of favor.
Next Steps
In order to prepare for an eventual upturn in the home builders, which one do we choose?  I looked at the charts of all the highest market-cap stocks in the group, and picked two I like the best.
I've only looked at the technicals for this study because fundamentals have not worked at all in this market.  Another reason is that the home builders themselves have very little to brag about in terms of earnings.  With that in mind, let's take a look at our first idea:
Toll Brothers (TOL)
This home builder is the largest in the group by market capitalization ($3.4 Billion).  Based in Horsham, PA, it's latest filings show that revenue comes almost equally among four U.S. regions:  Mid-Atlantic (29%), West (27%), North (23%), and South (21%).  It is one of the few stocks in the group to actually show a gain, year to date, +7.2%.
Chart 2
Toll Brothers vs. S&P 500

Although TOL has had quite an up and down ride this year, the overall movement has been positive.  Normally, this type of "snaking" action is seen on a smaller time frame, such as 1 or 2 months. 
The technical analysis interpretation of such behavior is that there is indecision in the markets.  The bulls (buyers) and bears (sellers) are engaged in a good, old round of fisticuffs.  There is not enough overwhelming momentum one way or the other to drive the price higher or lower.  Eventually, one will give up trying, and the stock will trade in the direction of the winner.
Technicians, like myself, use trend lines to get a hint at which way the break out will go.  Once the price chart (gray/white line) breaks above or below the yellow trend lines, we will likely see a continuation in that direction.
The other way that technos play a range like this is to buy when the stock approaches the bottom trend line, expecting a bounce.  They sell when the stock gets near the top trend line.  This is a chicken or the egg situation, because the behavior of indecisive traders causes the chart pattern, which draws in more directionally-uncommitted traders. 
No matter, the overall chart is telling us that TOL is relatively more attractive than it's peer group (-28% on the year), and is currently gaining steam on the S&P 500 (green line).
NVR, Inc (NVR)
This home builder, based in Virginia, is about 2/3 the size of TOLL.  It, too, is up on the year (5.5%), and trades at an attractive 5.5 PE on positive trailing earnings. 
NVRbuilds homes and provides mortgage banking services.  Sixty percent of it's sales come from the Mid-Atlantic, with another 38% along the North East to South East U.S. corridor.  Less than 2% of revenues are related to mortgage banking.  Two of it's trade names are Ryan Homes and NVHomes.
Chart 3
NVR, Inc vs. S&P 500
Chartwise, it's pretty similar to TOL, above.  The unique thing about this chart is that the oscillating pattern is getting tighter and tighter.  Trace the chart from mid-2006 through today, and you'll see the swings becoming smaller.  The swings actually started back in 2004, off the left-side of this chart.
This pattern also presents indecision, but more advanced.  The swings are the bulls and bears tugging it out, but the smaller range over time shows that some modicum of agreement is being worked toward.
For example, from mid-2006 until early 2007, the stock doubled from $400 to $800/share.  After losing almost all of those gains by the end of 2007, it regained 200 points back, to 650.  The drop from early 2008 at 650 down to just under 500 shows a narrowing of the range.  Back to 600 recently and down again, but not all the way to 500.
If you are getting dizzy, I don't blame you.  The uncertainty that normally causes charts like this has been exponentially applied to the housing market over the past couple of years.
I still believe that the home-builders are forming a bottom here, albeit not very smoothly.  There is still a lot of uncertainty about the future of mortgages and credit availability, home-inventory, governement interaction/regulation, the Presidential election, etc.  However, as we discussed last month, the 2001/02 recession saw the home builder stocks rebound much earlier than the general market. 
We are in a very low interest rate environment, and eventually the housing market will return, as it always does.  By the time that is obvious to everybody, the good home-builders will have to be bought at levels much higher than they are now.
As always, if you aren't interested in researching individual company prospects, the two ETFs that I often use are the XHB and URE.  The latter is an Ultra, or double mover, of the Dow Jones US Real Estate Index, which is similar to the XHB.
Dan Grill