360 Degrees of Homebuilders

The homebuilders could have gotten giddy, at least in their sentiment survey, but chose not to do so. Homebuilders have seen booms and busts before, and they were determined not to confuse a bull market for brains.

If only Wall Street kept such a clear head. A casual observer might think there are some out-of-control egos in this business.

The Interest Rate Connection

But if homebuilders kept their cool on the way up, they certainly panicked on the way down. The relative performance of their stocks has fallen, and with it, so have their spirits.

While you may think they are manic-depressives without the benefit of the occasional mania, they are actually reflecting the abyss created by the interest rate mechanism discussed above.

Prior to August 2005, their sentiment index reflected the national average rate for fixed-rate mortgages so well that it was simply a redundant indicator.

But what the small rise in mortgage rates -- from below 5.5% to above 6.5% -- did was close the door behind the deluge of marginal new homebuyers who had flooded into the market.

The builders satisfied 2006-07 demands in 2002-05. They will have to wait for the next wave of homebuyers, and given how homes define durable goods, that may take many years.

A Picture of Homebuilder Confidence

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Source: Bloomberg

Mortgage Rates and Homebuilder Sentiment

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Source: Bloomberg

Another way of looking at this interest rate relationship is by updating and expanding a complex chart from my August 2005 column on homebuilders. The rate-cut era began in January 2001. We can divide the next five-and-a-half years into three regimes, the one prior to July 2003, the one after August 2005 and the one in between these two.

If we map the relative performances of the homebuilders against the relative movements of 10-year note yields and superimpose trend lines on them, we see how both the pre-July 2003 (green trend line) and post-August 2005 (red trend line) periods show strong dependence on interest rate trends. The middle segment (blue trend line) had only a weak relationship to rate trends.

Yield Curve Effect

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Source: Bloomberg

We can also, on the chart above, map the relative performance of the homebuilders against the shape of the yield curve as measured by the forward-rate ratio from two to 10 years. This is the rate at which we can lock borrowing in for eight years starting two years from now. During the pre-July 2003 period, the yield curve was fairly steep; the homebuilders as a group tend to do well in a steep yield-curve environment.

The present yield curve is quite flat, which works against the homebuilders. Overall, we have to conclude the group is left wishing for a combination of lower long-term rates, a steeper yield curve and a stronger economy. While nothing is impossible, this combination is unlikely to occur anytime in the foreseeable future.

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Don't Move Into Toll Brothers Yet, by Jim Cramer

This column was originally published on RealMoney Aug. 22 at 9:17 a.m. EDT. Toll Brothers(TOL Quote) is so bad, let's go buy some. That's what I thought this morning when I saw the concentrated buying in the stock after the earnings came out. What did these buyers expect? That Toll Brothers was going to plow under new homes, and when it didn't, it was a buy? Did they expect that Toll Brothers would say it is getting out of housing because it is so bad and getting into Toll House cookies? Are they kidding?

To me there was nothing good here: another number cut, another statement about how housing is slowing, another reduction on top of a reduction. No sign that inventory is being worked off yet.

Sure, every stock is entitled to a bounce. But, I urge you to read Helene Meisler today. She tells you exactly what will happen, from a technical point of view, to the stock. I couldn't agree more. A classic sell-into-strength situation.

When do you buy Toll? As the playbook says, after the first cut in rates. Don't bother to anticipate it; that won't work.

Just wait if you don't own it, and if you do, be grateful for any bounce you might get.

At the time of publication, Cramer had no positions in stocks mentioned.