Mortgage-Based Stocks May Dwell Lower - TheStreet

Rather than a predictable preamble about how interest rates are at a point of diminishing returns, or feigning amazement that rates leapt even higher Tuesday despite Federal Reserve Chairman Alan Greenspan's continued "accommodative stance" (for that would be rehashing the obvious and of little value), I'll say simply that stock prices of many mortgage-based businesses are becoming increasingly vulnerable and ripe for a bearish position.

We've already looked at ways to

short the bond market, and they have paid off nicely, as rates on the benchmark 10-year Treasury note have surged to 3.91% from 3.12%. Let's look now at an options strategy that takes a bearish stance on a company whose revenue is directly tied to mortgage activity volume.

I believe mortgage activity, while remaining relatively robust, has also seen its peak. On June 18, the Mortgage Bankers Association Index of mortgage loan application activity hit an all-time high of 1707 for the week, and the average rate for a fixed rate 30-year mortgage hit 4.99% -- its first (and possibly last) time below 5%. Since then, the mortgage application index has dropped 21%, and rates on the 30-year mortgage have jumped to 5.35%.

"By 2005, the mortgage volume in the market should be back at 1998 levels," says Douglas Duncan, chief economist with the MBA. Its most recent report expects mortgage originations to hit a record $3.39 trillion in 2003 but fall 43% in 2004 and drop 25% in 2005, bringing volumes down to $1.46 trillion, or less than half current levels.

Squeeze Screen

Because many of the companies in this group have become favorite targets of short-sellers, I wanted to screen out stocks that are potential short-squeeze candidates. I focused on a few simple factors: Shares should be trading within 10% of their all-time high, the short interest should be below 10%, and the days-to-cover ratio should be less than five days.

For example, I took a pass on

NovaStar Financial

(NFI)

. Although its price of $72 is just 2% below its all-time high, and its business of buying and issuing nonconforming loans makes it especially vulnerable to rising interest rates and a weak job market, I'm not comfortable shorting it, because short sales represent an unbelievable 93% of its share float. And with a total float of just 3.5 million shares, there's no telling how high it could shoot if shorts were forced to cover.

In

Countrywide Financial

(CFC)

, however, we have a stock that has run up some 71% over the past 52 weeks, and at $70.50 on Tuesday it was still just 10% off its all-time high. The short interest is just 5.4%, and the days-to-cover stands at a very manageable 3.2.

More importantly, recent chart action paints a bearish picture and provides a low-risk entry point.

Countrywide Rides Mortgage Wave
Its shares are up more than 70% this year

The formation that follows the gap up in late April is starting to look like a massive top. While it's not perfectly symmetrical, one could make a case for seeing a "head and shoulders." The right shoulder on its own is a bearish flag; its inability to break through the resistance at the $72 level makes this a great place to start selling. Stops should be placed near $73 to minimize risk.

The immediate target is the gap at $63. If that is filled but fails to provide much support, the stock could easily drop another 15% to the low $50 area.

Countrywide is set to report earnings on July 22. I think this stock could continue to drop lower over the next four to six months, so I'd look at some long-dated put spreads. One example might be to buy the $60 January 2004 put and sell the $50 January 2004 put for a net debit of $2.20. This leaves you a maximum profit potential of $780, or 350%, for each spread.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.