With Bears Back in Charge, Short Hovnanian

The Fed dropped a bombshell the other day, lowering both the discount rate and the fed funds target rate by 50 basis points. That started a fire under the homebuilders, driving all of them up above their 50-day moving averages -- something that hasn't occurred in several months. It also pushes some of them into potential shorting territory, which we'll look at momentarily.

But first, let's talk a little more about the Fed action and its effect on the sector.

While the Fed rate cut is helpful on a lot of levels, the market is quickly realizing that it is not the panacea for the homebuilding sector that many had hoped for. You see, the problem with the homebuilding business really doesn't implicate interest rates. Rates are plenty low by historical standards.

The problem with the homebuilding business is the inability of prospective homebuyers to get a loan that meets their needs. Additionally, the supply of homes still far exceeds demand, even though housing starts have declined.

Simply put, it's gonna take a long while for demand to chew through all the supply in the market. And even though supply is plentiful, the homebuilders are still building. Homebuilders build ... then they sell. But this building will certainly prolong the slump in housing -- a slump that I've been saying will last until 2010 at the earliest.

With that as the backdrop, we're going to look at shorting Hovnanian (HOV - commentary - Cramer's Take).

First, notice how the stock pushed well above the 50-day moving average on Tuesday. A pretty solid move, with the stock having run almost 60% in just a few days. Think that was real buying? Think again. I think it was largely driven by short-covering, which prompted the stock to gap higher Wednesday morning and then sell off for the rest of the day -- right back to the 50-day moving average. Once the panicked shorts had covered, there was just no follow-through.

Thursday, the stock traded down through the 50-day moving average and closed near the bottom of the range. That's a big sign of weakness.

With the market now starting to run on all cylinders, I doubt there will be much patient money willing to sit in HOV ... or any homebuilding stock ... for quite a while. At some level, the homebuilders are a value investment. But portfolio managers are now going to be chasing the market, trying to beef up their performance. I doubt many will think they'll get the job done in this sector.

So the short entry on Hovnanian is at $12.10 -- Thursday's low. If the stock prints that price again, then we have a pretty good sense that Thursday's weakness we just the latest rejection of a short-covering rally. Once that trade is opened, we'll keep a protective buy-stop at $13.55. With a downside target of $10, that gives us a decent risk/reward profile for this trade.

If you have any questions about this one, please let me know at [e-mail]

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At the time of publication, Fitzpatrick had no positions in the stocks mentioned, though positions may change at any time.

Dan Fitzpatrick is the publisher of StockMarketMentor.com, an advisory newsletter and educational forum dedicated to teaching effective risk management and trading methodologies to aspiring traders and investors. He is a former hedge fund manager and a member of the Market Technicians Association, and he now trades from his home in San Diego, Calif. While Fitzpatrick holds various securities licenses, he does not give recommendations to buy or sell stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback; click here to send him an email.