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The stock market doesn't want to see optimism from home builders right now.
Sentiment in the housing sector is so negative that good news like Tuesday's report of a 5% jump in housing starts for May was interpreted as bad for housing stocks. On average, the group fell by another 1.9% on concerns that a rise in groundbreaking while sales are falling means that housing companies are adding inventory.
Increased inventories during a period of slack demand means lower prices and declining margins and profits.
Profits in the sector are already coming down. Just the other day, KB Home (KBH, news, msgs) cut its current-year earnings estimate to $10.00 per share from prior guidance of $11.25 per share. Earlier in the month, Pulte Home (PHM, news, msgs) slashed its second-quarter and current-year estimates. Both firms cited a slowing in orders and rising interest rates for the revised numbers.
Data is decidedly dour
Wall Street is busy slashing estimates across the group as downright brutal news comes out. Aside from the jump in starts reported yesterday, which is normally a good sign, investors are digesting a steady decline in the pace of new and existing home sales.Add in the fact that the National Association of Home Builders confidence index dropped to its lowest level in 11 years and it's a pretty safe bet that future starts and sales numbers will continue to erode.
The question at this point is will that erosion be slow and steady, or will the sector melt down? Yesterday's housing-starts numbers, which were up from the prior month by 5% but still down by 3.8% year-over-year, suggest that the slowdown in housing will be orderly.This is consistent with what the Federal Reserve has been arguing for months. But it is in the Fed's interest to cushion the decline in housing and prevent Wall Street from becoming overly bearish. Such a dislocation could prove harmful to the overall economy. So, we need to look elsewhere to try and gauge just how severe the slowdown in housing will be in the months ahead.
A beat-up sector
Look at these ten housing companies: Beazer Homes USA (BZH, news, msgs), Centex (CTX, news, msgs), DR Horton (DHI, news, msgs), Hovnanian Enterprises (HOV, news, msgs), KB Home, Lennar (LEN, news, msgs), Pulte, Ryland Group Inc. (RYL, news, msgs), Standard Pacific (SPF, news, msgs) and Toll Brothers (TOL, news, msgs).This group is down a whopping 37.3% year-to-date. And each stock broke below its 200-day moving average earlier this year, confirming the change in trend.
But what about going forward? One sign of trouble to come is that earnings estimates in the sector have been coming down hard over the last three months. Declining earnings estimates are almost always a precursor to bad news.
Estimates down, but not enough
What's startling is that despite the torrent of negative news over the past several months, Wall Street seems to be behind the curve in terms of lowering future earnings. Looking across the group, earnings as a whole are expected to drop by a mere 3.6% in the current fiscal year and by a relatively modest 14.8% next year.Considering that the Fed made it pretty clear that rates are headed still higher, that speculators have turned from net buyers to net sellers and that the NAHB is forecasting a 9% year-over-year drop in starts, earnings estimates still look too optimistic.
Still, it's not unusual for the Street to play catch-up, especially during the early stages of a sector reversal. And this is still very early in the group's decline.
High leverage, expensive stocks
Another potential hit to earnings will come from the fact that balance sheets throughout the sector are highly leveraged. This will hurt the group now that rates are heading steadily higher. Instead of using cash to add inventory, builders might want to consider paying down debt. Unfortunately, most of the firms had negative cash flow over the past year.Video: Walberg on woes of the home builders
As unbelievable as this may seem, housing companies are just coming to the realization that the good days are over. Streamlining efforts like those announced by KB Home, which will cut 7% of its workforce, are just beginning to be put into effect. Investors should expect more such announcements in the weeks and months to come, as the industry adjusts to the deteriorating environment.
In short, the news cycle will continue to be negative for at least another six months or probably longer. And don't be fooled into thinking that the group is now undervalued.While the average multiple to earnings is a modest 5.4-times fiscal-year 2007, it should be noted that future estimates will be coming down hard. Traditionally, the group bottoms when it sells for closer to 4-times earnings.Considering the potential erosion in earnings, the stocks are still overpriced by at least 25%. On a short-term basis, the sector is oversold and a technical rebound of 10% or so can't be discounted. But given the lousy economic backdrop, deteriorating earnings picture and overtly bearish technical tone, investors should sell into any near-term rallies.
At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this article.
Robert Walberg is a financial writer based in Chicago, Ill. He was formerly chief equity analyst at Briefing.com. He is a regular guest on CNN's Moneyline and CNBC's Squawk Box. Mr. Walberg ran for Congress in Illinois in 1994.