The homebuilders are rising again, and for good reason: They are beginning to discount better conditions in the housing market. The advance has caught the attention of some analysts. Bank of America Securities analyst Daniel Oppenheim upgraded several of the builder stocks today, saying he sees an "improvement in traffic, affordability and construction trends." The companies on his upgrade list were Toll Brothers (NYSE: TOL ) , Pulte (NYSE: PUL ) , Ryland (NYSE: RYL ) , Meritage (NYSE: MTH ) , and NVR (NYSE: NVR ) , which all went from sell to hold. (Foolish readers were apprised to buy Toll Bros in my Sept. 19 article. The stock was almost 20% lower back then.)
Even with the upgrade and recent stock rally, many analysts still remain cautious -- if not outright bearish -- on the sector. On a Fox News business show not too long ago, I reiterated my bullish outlook for Toll, only to be chided by many of the show's panelists. (That is almost always a good contrarian sign.)
Oppenheimer himself seemed to proceed with caution, despite his upgrade. "We do not expect a smooth upward move, but expect choppiness over the next 12-24 months based on the excess inventory, as it will take time to work through the oversupply," he said in Thursday's research note to clients.
He fails to see the big picture, as do so many of the current housing bears. They remain micro-focused on inventory without seeing inventory in relation to sales. They fail to put inventory in context, which is a serious analytical mistake. Every industry looks at the inventory-to-sales ratio, and housing should be no exception. Having said that, consider that the ratio of single-family housing starts to sales is now at the lowest level since the government started recording this data in 1963.
The decline of housing-related stocks started last year and seemed to forecast a bad turn in the numbers. However, it is doing just the opposite: It is pointing to an improvement. The stage is set for an extension of the current rally. Stop listening to these know-nothings talk about the inventory, because it will soon be coming down -- and when it does, they will be scrambling to upgrade their views. At the same time, their clients will be rushing to buy stock.
You want some more evidence that a turnaround is at hand? Well, how about the fact that in October, single-family housing starts hit their lowest level since 1997? Furthermore, you have to go back to the 1990-1991 recession to see a year-over-year drop in housing starts as steep as the one that we have recently seen. The rapidity and magnitude of this contraction has been extreme, particularly when viewed against the backdrop of a 4.4% unemployment rate (the lowest in a decade) and decent, 2.2% GDP growth. We are far, far from being in a recession, yet builders have reacted as if we are mired in one.
The builders themselves don't even think things will get better. Remember, they were so cocky and confident in early 2005, but for them a turnaround is nowhere on the horizon. Robert Toll, the chairman of Toll Brothers, recently made this comment in the firm's guidance earlier this month: "We continue to look for signs that a recovery is imminent but can't yet say that one is in sight ." Contrast that with his unbridled optimism through the first half of 2005 (although he did sell a lot of stock at that time). Other companies share a similar view.
When the turn comes, they will remain cautious, as they have done in the past. This will accelerate the depletion of inventory and cause prices to rise again -- but more rapidly than anyone expected. By the time the homebuilders respond with expanded output, the stocks of these companies will be significantly higher in anticipation of much higher earnings.
Another important factor -- interest rates -- is working in the homebuilders' favor, too. Rates are falling, and that means affordability is rising. The benchmark 10-year Treasury is currently at the lowest level in 10 months and trending lower. Mortgage applications (purchases) have risen 20% in the past five months, while refinancing applications have climbed nearly 50%. The latter will put money in current homeowners' pockets, making it possible for them to "trade up" to larger, more expensive, or even newly constructed homes if they desire.
As I said, the stage is set. Homebuilders reacted well to the market downturn, and their numbers look good. More importantly, the economy is on decent footing. Sentiment also looks very supportive, notwithstanding some isolated upgrades, as in the case of the Bank of America analyst. (Anyway, his upgrade was still cautious at best.) I think the forecast for "choppiness" is wrong. Smooth sailing is more like it.
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Fool contributor Mike Norman is an international economist and founder of the Economic Contrarian Update. He can be seen on Fox News, where he appears as a business contributor. In addition, he hosts a radio show on the BizRadio Network. He owns shares of Toll Brothers. The Fool has a disclosure policy.