The Rude Awakening
Wall Street, New York
Thursday, February 2, 2006 ------------------------- - So, one professional investor says to another…
- Still pounding nails - five major homebuilders turn
in their report cards and,
- It's your turn to send us an email for the next Rude
Mailbag
------------------------- Eric Fry, reporting from the belly of the beast on Wall
Street… "Did you see the numbers on Downey Financial?" A friend and
hedge fund analyst asked yesterday. "They were crap, and so
were Washington Mutual's. If these mortgage lenders are
having problems, the homebuilding stocks are all gonna get
whacked." "I'm not so sure," a second professional investor replied.
"I think you might be jumping the gun. There's little doubt
that the homebuilders are a big, fat short sale, but
probably not yet." "I think you gotta short 'em now," the first hedge fund
analyst insisted. "The fourth quarter numbers sucked at
every single mortgage company, and the first quarter will
suck also. That's telling you there's problems in the
housing market." "That's where we disagree. Earnings at the mortgage banks
are disappointing, but not because of slowing loan demand.
Falling interest margins are the problem…and that's got
very little to do with demand for housing. Why don't you
just short the lenders and ignore the homebuilders for
awhile?" "Because the homebuilders are the next ones to stumble,"
the first analyst continued, refusing to yield his ground.
"They may well be," the second analyst said. "But they
might not stumble for another four months…or four years.
They certainly aren't stumbling now." "Yeah, but home sales volumes are dropping and inventories
are rising. It won't be long now before the stocks tank."
"You may be right," the second analyst conceded. "But I
think the first quarter's gonna be okay for the housing
market…The hurricanes are history; in fact, the slowdown
from the hurricanes might push some home-buying into the
first quarter of this year. As for energy prices, oil is
still high, but natural gas has dropped a lot. In fact, it
has fallen about 40% since mid-December, and heating oil is
also down a little. So now that things have normalized
somewhat, the buyers might return." "Yeah, but if your wrong," the first analyst warned, "if
home sales don't materialize in the first quarter of 2006,
you'll miss a big chance to short these stocks." "Absolutely, I agree with that. But if YOU'RE wrong, you'll
get squeezed and lose money while waiting for the stocks to
fall. I think the homebuilding stocks will be much, much
better shorts - and much safer - after the first-quarter
numbers come out. So I'd be looking to short these stocks
in late April or early May…Not now. And if I miss my
chance, I miss my chance." Your editor is inclined to agree with analyst No. 2. But
before jumping to conclusions, let's consider some of the
evidence…
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By Eric J. Fry America's rollicking housing boom appears to be winding
down…but it may not be over just yet. So, to those folks
who might be itching to short the housing stocks, we'd
offer a modest suggestion: Don't scratch. Although we, too, find the urge to scratch this itch almost
impossible to resist, the details of a few first quarter
earnings reports are suppressing the impulse. Many mortgage
lenders, for example, are suffering the slings and arrows
of narrowing net interest margins, disappearing "gain-on-
sale" margins and rising delinquencies. But very few of
them are suffering from the one trauma that most of us
would expect: waning demand for home-purchase mortgages. In other words, the lenders might be issuing unprofitable -
or stupid - mortgages, but they are still issuing
them…which means that many folks in many places are still
buying houses. And we think they will continue to buy
houses at a very healthy clip throughout the first quarter
of 2006. The combination of deferred home purchases from
the final quarter of last year, and the presence of
relatively low long- and short-term interest rates,
suggests that home-purchase activity may surprise to the
upside. Net-net, we suspect that the investors who are
anticipating immediate woeful tidings in the housing market
will be woefully disappointed. The short-sellers of homebuilding stocks on February 2,
2006 probably are not "wrong," just early. Like these
bearish prognosticators, we also believe that the housing
boom has crested. But unlike them, we expect the slant of
the coming down-cycle to more closely resemble a "bunny
slope" at Vail than a "double diamond"…and this
particular bunny slope might contain a few surprise jumps
along the way. The present-day bears on housing tend to cite the fact that
home sales volumes have slipped from last year's heady
levels. 
The bears also harp about the recent string of earnings
disappointments and warnings from a few mortgage
lenders…and from a very selective sampling of
homebuilders. We have also observed these recent
disappointments. But we would point out that the nation's
largest homebuilders have NOT produced disappointing
earnings or sales forecasts.
Furthermore, many of the mortgage lenders that missed their
earnings estimates for the fourth quarter blamed narrowing
interest margins…not slowing demand for mortgages.
Yesterday, for example, mortgage behemoth Countrywide
Financial announced that its fourth-quarter earnings fell a
couple pennies short of the consensus estimate. The
culprit: plummeting lending margins. The company's so-
called gain-on-sale margins tumbled from 61 basis points
one year ago to a nearly invisible 9 basis points in the
fourth quarter of 2005. Meanwhile, however, the company
posted a record-high mortgage origination volume of nearly
half a trillion dollars. In other words, Americans are
still borrowing money to buy houses. Moving to the builders themselves, we find very little
evidence of impending doom. The table below presents the
fourth quarter earnings results of five major homebuilders.
All five companies posted large double-digit gains in net
income, revenues and order backlogs. And all but one of
them maintained or increased its earnings forecast for
2006. 
If this is a housing bust, every homebuilder in the country
would wish for a perpetual bust. Don't get us wrong; we
realize that backlogs have a nasty habit of disappearing on
short notice, and we are also well aware that the inventory
of unsold homes continues to inch higher. But the miserable
performance of homebuilding stocks since last summer seems
to amply discount these facts. The S&P Homebuilding Index
has slumped nearly 15% since last august, while the S&P 500
Index has gained about 5%. So a little "catch-up" might be
in order.
trade - than to sell them short. A hedge-fund-style
investor might do well to buy call options on the HGX
Housing Index against a short-sale of the S&P 500. Rest
assured, however, despite our temporary foray onto the long
side of the homebuilding stocks, we remain loyal to the
long-term bearish case.
Net-net, we'd be more inclined to buy these stocks - for a
We are merely prodigals, not deserters…and we will return
to the bearish-on-housing fold again one day…perhaps as
early April or May. [Joel's Note: There is no way you can know exactly when the
bottom will fall out of the housing market. It may be
tomorrow, it may be in a year. All you can do is prepare
for when this moment comes…and it will. Read on below to
find out how to protect your biggest investment: Housing Bubble Update:
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before the hangover wears off. http://www.agora-inc.com/reports/FST/EFSTG200 ------------------------- [Joel's Note: After the inaugural Monday Rude Mailbag I
received a healthy number of emails with some great
investment insights. Remember, this is YOUR column. The
ideas are yours and the response to these ideas is also
entirely up to you. If you have comments on any of the Rude
mailings throughout the week, or investment ideas of your
own that you would like to share, send them to
aussiejoel@the-rude-awakening.com We'd love to hear from
you. You may even end up seeing your email in print the
next Monday. I look forward to hearing from you. Cheers, Joel | 
