U.S. Housing Market

Homebuilder stocks have come out of the penalty box (the group is up ~28% on average YTD, with a couple of names already having doubled in the last quarter alone). If the Dow is indeed bottoming out, it is comfortable to say that homebuilders will have telegraphed a recovery in the major index -- only the future will tell. In the meantime, investors should take the grim headlines with a grain of salt and remember that homebuilders are taking actions to weather the industry blowup: reducing inventories, amending covenants, and maximizing cash flow as they shift to a supply rather than demand driven model. These is an incrementally more positive outlook going into the spring selling season, where there is arguably room for consensus to be surprised -- looking at the charts of some homebuilder stocks.

The worst had already been discounted into some homebuilders at the start of the year. It may be premature in calling these stocks strong buys, but we did want to point out the technical similarities between the Dow Jones and homebuilding space. History has proven over and over again that when headlines are most negative and consumer sentiment can’t get any more pessimistic, the smart money is buying stocks. And no space – other than the financials – has gotten more negative press than the homebuilders.

Given the heavy pessimism that now exists, which suggests that expectations are quite low and that there is a lot of liquidity on the sidelines, it is possible the stock market may hold up reasonably well in the face of bad news and rally on any good news. Psychology could conceivably shift towards the notion that the first quarter will represent the trough in corporate earnings, and that the worst of the housing and credit crisis is behind us. We don't share this view, but it may come to predominate for a period of time.

A catalyst to further the idea that the housing and mortgage markets are at a bottom could come in the form of a government mortgage bailout plan (whereby the government insures hundreds of billions of dollars of troubled mortgages). Bi-partisan momentum is building for such a government mortgage plan, as indicated by John McCain's reversal on this issue last week to support large direct government assistance to troubled homeowners.

The chart above from the Dallas Fed shows scheduled mortage re-sets through the end of 2008, and indicates that mortgage resets peaked in June 2008 at about $55 billion, and will be down close to $30 billion by yearend. In other words, the worst of the subprime problems might now be behind us.