Market Worries Hammer at Homebuilders

Homebuilder stocks tumbled Tuesday after a closely watched builder confidence index dropped to the lowest level since the last major U.S. housing slowdown over a decade ago.

The report added more negative sentiment to a sector that has been in rapid selloff mode since last week, when D.R. Horton ( DHI), the country's largest homebuilder, slashed its earnings guidance .

Increased concerns about interest rates and housing affordability caused builder confidence in the new single-family homes market to drop to a reading of 39 for July, according to the National Association of Home Builders/Wells Fargo Housing Market Index, or HMI. The index gauges builder perceptions of current sales and expectations for the next six months; any figure below 50 means more builders view sales conditions as poor than as good.

"The HMI is down from its most recent cyclical high of 72 in June of last year, and reflects growing builder uncertainly on the heels of reduced sales and increased cancellations related to eroding affordability as well as an ongoing withdrawal of investors/speculators from the marketplace," NAHB Chief Economist David Seiders said in a statement.

In terms of historical comparison, the downward movement of the confidence index is essentially in line with readings from the 1994-to-1995 U.S. housing slowdown period, the NAHB said. During this period, the Federal Reserve tightened monetary policy, and the housing market went through a fairly orderly cooling-down period, Seiders said.

However, a recent analyst report suggests that the downturn this time around will be uglier, claiming that a comparison to the 1987-to-1991 housing downturn (which was worse than the 1994 period) is more warranted.

Raymond James analyst Rick Murray says the inventory levels are more challenging today, on the basis of absolute levels of inventory (565,000 today vs. 358,000 in the late 1980s) as well as months' supply of homes on the market (5.8 months today vs. 5 months then).

"Some pundits have prophesized that inventory levels should moderate, based on many investor cancellations having already been dealt with; thus, cancellation rates should slow in the back half," Murray wrote in a report last week.

"While we do not disagree with the thesis that investor cancellations may be moderating, we believe that, based on discussions with our contacts, most cancellations today are legitimate buyers who are walking away from earnest money deposits out of fear of declines in home prices. Furthermore, we expect inventory levels to build even further in the back half."

Of course, some of the latest talk on Wall Street has been that builder stocks -- whose prices have dropped about 40% to 50% since January -- are now reaching levels of support at around book value.

However, during past troughs in housing cycles, builder stocks tended to trade down to about 0.9 times book, Murray says. In the late '80's, the stocks dropped to 0.6 times book.

An additional worry today is that builders' book values might be reduced because of land being overvalued on balance sheets. (Since builders report land at cost, the values could be impaired if they overpaid for the land. Recently some companies, including D.R. Horton, have been writing off the value of land options, which were no longer deemed to be profitable enough.)

As Carl Tash, founder of real estate hedge fund Cliffwood Partners points out, companies such as M.D.C. Holdings ( MDC) and KB Home ( KBH) own a lot of relatively new land that they purchased two to three years ago. "Is their book value reliable, or is it too high?" asks Tash, who has shorted builder stocks over the past year.

MDC fell 3.2% to $45.10 Tuesday. At that price, the company is trading at 1.02 times its book value. KB was trading down 3.1% to $38.12, or 1.05 times its book value.

In watching book value, investors might have more comfort in a company like Toll Brothers ( TOL) since it has a lot of older, less expensive, land on its books.

Investors should get more color about the builders through their earnings reports, which will begin trickling in this week. Raymond James has told investors to avoid the group, as the firm projects another 20% to 40% downside in the stocks as of last Thursday. Since then, some builder stocks are down about 15%.

Ryland ( RYL) reports Wednesday. Shares fell 5.7% to $34.34 Tuesday as investors anticipate the company to cut its earnings guidance.

M.D.C., and D.R. Horton (which preannounced last week), both report earnings Thursday.

NVR ( NVR), which was down 4.5% Tuesday, reports Friday.

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