This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we've got a whole tract of homebuilder ratings under construction, as MKM Partners does a complete remodel of its industry ratings. First up...

The bad news
Housing stocks have enjoyed a banner year in 2012, with shares of top homebuilders like D.R. Horton (NYSE:DHI) topping 60% gains since Jan. 1, Lennar (NYSE:LEN) up more than 80%, and Ryland (NYSE: RYL) approaching a clean double. But one analyst thinks these stocks have become victims of their own success, and now boast valuations so far above what they deserve as to doom the stocks to subpar performance -- or worse -- in the year ahead.

This morning, MKM Partners acted on its strong suspicion, downgrading all three stocks. D.R. and Lennar both had their "buy" ratings pulled and were downgraded to "neutral." Ryland suffered the cruelest cut of all, a veritable analyst wrecking ball of a rating, as MKM cut its recommendation all the way down to "sell."

Why? The numbers tell the tale. At 1.9 times book value, D.R. Horton is currently the cheapest of the lot -- despite the fact that its valuation is now twice the "1.0" level at which value investors think homebuilding stocks usually become buyable. Lennar's even less of a bargain at 2.2, while Ryland, the stock MKM loves to hate, scores a nosebleed 3.1-times-book-value valuation.

It probably doesn't help that Ryland is currently also the only stock of the three that shows negative profits for the trailing-12-month period. But even D.R. Horton and Lennar, at 11.6 and 7.6 times trailing earnings, respectively, appear to bring serious risk of a letdown next year. Based on forward earnings estimates, each stock sells for a forward P/E ratio of more than 22 -- quite a heady multiple, given that most analysts think profits are close to peaking, and both stocks are likely to be stuck at mid-single-digit growth rates for the next five years.

The good news
And yet, there is still one homebuilding stock out there that got some good news from MKM this morning: Hovnanian (NYSE:HOV).

Alone in the industry, Hovnanian received an upgrade from MKM today. Problem is, it's hard to see why. As it's unprofitable based on trailing results, few analysts see Hovnanian earning a profit next year either. Its projected growth rate, such as it is (remind me -- how exactly do you grow profits when your profits are negative to begin with?), is right in line with the rest of the homebuilders at 5%. Perhaps worst of all, Yahoo! Finance says this stock has an actual negative book value -- negative $4.08 per share, to be precise.

Considering all the numbers weighing against it, it's surprising to note that this stock -- up more than 150% since the year began -- has actually outperformed all three of the stocks that MKM is downgrading today. And maybe that's the real reason that MKM decided to throw in the towel and stop recommending that investors sell Hovnanian.

Not because it was wrong to do so. (It wasn't.) Not because the stock isn't a dog. (It is.) But because at some point, the pain of betting against an irrational stock market just gets to be too much to bear.

Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above.


This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.