Real Estate's Top Looms

The residential real estate market today reminds me of a milder form of the Nasdaq in early 2000.

About a year and a half ago, I wrote a piece called, "The Fundamentals of Market Tops." I encourage you to reread that piece before reading this one, because it will give you a framework for how I evaluate bubbles, and I will apply that framework to the residential real estate market. As opposed to my earlier article, I will try to show why there is reason for pessimism and why we are close to a market top in residential real estate.

This analysis, which does not represent the views of the firm that I work for (even though my views of macroeconomics largely represent the firm's views, I don't directly control all of our investment actions), primarily applies to the hot coastal markets, where I believe there are a bunch of bubblettes developing. It does not apply to the nation as a whole, although I do believe that the bubblettes will not pop individually, but as a group, because excess liquidity is the common factor that will eventually be removed. Furthermore, when the bubblettes pop, residential real estate prices in the U.S. will fall for at least one year in aggregate, which would be a new phenomenon (at least since the Great Depression) and have large repercussions for the financial sector.

As a result, I am bearish on all of the homebuilders and the mortgage insurers. The mortgage insurers carry all of the worst credit risks in mortgages. The relevant companies are MGIC Investment (MTG - commentary - Cramer's Take), Radian Group (RDN - commentary - Cramer's Take), Triad Guaranty (TGIC - commentary - Cramer's Take) and The PMI Group (PMI - commentary - Cramer's Take). (For what it's worth, MGIC is the most conservative of these.)

As for the homebuilders, I don't have a strong opinion on which companies will do the worst. A basket trade on the biggest should do adequately, though smaller firms should be hurt disproportionately. The five largest are D.R. Horton (DHI - commentary - Cramer's Take), Pulte Homes (PHM - commentary - Cramer's Take), Lennar (LEN - commentary - Cramer's Take), Centex (CTX - commentary - Cramer's Take) and Toll Brothers (TOL - commentary - Cramer's Take).

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.