March 6th, 2006

Selling Homebuilding Stocks Short?

We haven’t heard much recently about homebuilding stocks but a year ago they were the stocks to own. It’s understandable with everything that’s been written about an impending bursting of the “real estate bubble”, the Fed’s continual ratcheting up of short-term interest rates and the overhang in the inventory of both new and resale homes.

I last wrote about the group in my October 11, 2005 post; at that time, I said that homebuilders:

appear to have peaked in August and, as a group, are approaching a major support level. If they are unable to bounce significantly above that level (through the August high), then the long bull market that’s carried most stocks in the group to a 6-10 fold increase since interest rates began to fall in 2000 (some going back to 1990) will come to a temporary, though sustained, halt. IBD includes 21 stocks in the group and any look like possible shorts, although those who are more conservative may until the support is actually broken.”

While there’s an ETF for the homebuilders (SPDRs Homebuilders EFT – XHB), it was just launched at the beginning of February so it is too new for any meaningful sort of picture. The chart of IBD’s Building-Residential/Commercial Industry Group (the one I included in my October post), however, summarizes the group’s situation. In fact, the group index did bounce off the resistance level at the end of October and developed the left shoulder of a perfectly formed head and shoulder formation.

If charts like the one above were flipped upside down I would have no hesitation saying (and have often said just so) that “a breakthrough of the resistance level triggers a buying opportunity”. In this situation, would a breakdown of the support level not indicate a shorting opportunity? I believe the main reasons we don’t is because 1) over time, the market has historically gone up and 2) the knowledge that there is a maximum risk of loss when owning (it can go to zero), the risk is unlimited when shorting.

As a group, the stocks in the industry have already retreated 25-30% from their peak last summer. Caution dictates asking whether there’s further room on the downside and, if so, is there a trading opportunity here (selling short or buying puts) and how could it be played (to see graph, click on symbol)?

  • Brookfield Homes (BHS)
  • Hovnanian (HOV)
  • KB Home (KBH)
  • Meritage Homes (MTH)
  • NVR Inc (NVR)
  • Pulte Home (PHM)
  • Ryland Group (RYL)
  • Standard Pacific (SPF)
  • Toll Brothers (TOL)

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