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Sam Stovall's Sector Watch

By Sam Stovall

Homebuilders: Up from the Basement?

Stocks in the beaten-down sector may be ready for a short-term bounce, says S&P, but the fundamental outlook remains negative

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From Standard & Poor's Equity Research
The Aug. 22 announcement by Toll Brothers (TOL) of lower third-quarter earnings per share (EPS)—and that it had reduced guidance for the fiscal year ending October, 2007—is just the latest example of the homebuilding industry's woes. Shares of industry members have suffered this year, as the S&P 1500 Homebuilders subindustry index was down nearly 32% year to date through Aug. 18. From peak to trough (based on week-ending data) the Homebuilders index declined nearly 49% from its July, 2005, peak to its July, 2006, trough.

The relative strength chart pictured below shows a group that has clearly been hammered (pun intended). The dramatic decline puts me in mind of the Chubby Checker song Limbo Rock, in which he asks "How low can you go?" With this tune firmly in mind, I asked Bill Mack, CFA, S&P's Homebuilding analyst, if we had seen the lows for the group and whether it was buying time again.

UNCERTAINTY PRINCIPLE.  Maybe not. Mack says S&P's fundamental outlook for the homebuilding group is negative. In 2006, he looks for the average homebuilder's profits to be about comparable with the peak levels posted in 2005, following 30% to 40% average annual growth since 2000.

Although Mack still believes the fundamentals supporting growth in long-term demand for new homes remain sound, S&P is concerned about what it views as a lack of earnings visibility over the next 12 to 18 months. Most of its concerns are related to new-home sales figures, which began to weaken in the fourth quarter of 2005 and have accelerated downward during the first half of 2006.

Mack looks to late 2006 new-order results to provide a better indication of whether high current levels of home inventory are being reduced. Until equilibrium between supply and demand is better established, he thinks broad investment in the homebuilders is highly speculative.

Due to a heightened level of uncertainty as to consumers' appetite for new homes, S&P now thinks the average overall p-e on its lowered 2006 EPS forecasts will decline to about 5 times multiple, from slightly greater than the 7 times multiple of actual 2005 earnings where it finished this past year.

CAUTIOUS OUTLOOK.  Mack points out that sales of new single-family homes have been at or near record levels since 1998, aided by relatively low mortgage rates over this span. Still below 7% in mid-July, 30-year fixed mortgage rates were closer to their all-time low of about 5.25% than their average of about 9.2%, which dates to 1971. These relatively low borrowing rates have helped offset downward pressure on home prices resulting from a relative dearth in recent home-buying demand, according to Mack. S&P believes the rate on typical 30-year mortgages will finish this year at around 7%.

After nearly a decade of steady volume advances and relatively large price gains, there's now strong evidence that this homebuilding boom is now over, Mack believes. Although we expect the next cyclical bottom to be more manageable for large builders than past troughs, S&P's outlook remains very cautious, especially as it relates to smaller, less geographically diverse builders and the relatively highly leveraged operators. Mack thinks there's a strong possibility that new home demand will continue to worsen before it improves again.

So there you have it. Maybe we will see a technical turn for the group, but S&P thinks it will take quite some time before the homebuilders' fundamentals are again on solid footing.


Source: Standard & Poor's

Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry	Company	S&P STARS	Price (8/18/06)
Agricultural Products	Archer-Daniels-Midland (ADM)	4	$41
Construction & Engineering	Jacobs Engineering (JEC)	5	$86
Diversified Metals & Mining	Phelps Dodge (PD)	3	$90
Fertilizers & Agricultural Chemicals	Monsanto (MON)	2	$47
Gold	Newmont Mining (NEM)	4	$51
Ind. Power Producers & Energy Traders	AES Corp. (AES)	3	$20
Integrated Telecom. Services	AT&T (T)	4	$31
Investment Banking & Brokerage	Merrill Lynch (MER)	5	$76
Oil & Gas Equipment & Services	Baker Hughes (BHI)	4	$76
Oil & Gas Refining & Marketing	Valero Energy (VLO)	4	$62
Railroads	Burlington Northern Santa Fe (BNI)	4	$68
Steel	Carpenter Technology (CRS)	4	$99

Stovall is chief investment strategist for Standard & Poor's Equity Research Services

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