No investor wants to miss out on what could potentially be a huge recovery in housing stocks, rebounding after two painful years of depreciation. As a result, we believe the financial markets will be so forward-looking that a rally will occur well ahead of any trough seen across the industry's myriad of fundamental indicators.
The root cause of the problem, in our opinion, is inventory levels, which we believe will remain highly elevated over the next few quarters, causing even greater downward pressure on home pricing and other fundamentals. This, in turn, should result in more large impairment charges among home builders over the next few quarters, pushing out any reasonable near-term visibility for a trough. For home building stocks, this should cause further downside.
Supply Should Remain High
Although absolute inventory levels have recently stopped growing as fast, they're highly elevated and should remain so due to tighter credit/mortgage markets and higher foreclosure activity. While national existing homes available for sale rose 0.4 percent to 4.581 million in August following July's 4.4 percent rise, levels are up 19.2 percent year-over-year (YOY). Austin and San Antonio are up 50.6 percent and 43.9 percent YOY, respectively. Inventory levels remain elevated in several other key regions, with Riverside, Calif.; Jacksonville and Orlando, Fla.; Las Vegas; and Phoenix up 20–26 percent YOY.
More Pricing Pressure Ahead
Two measures–affordability and price-to-income (P/I)–help illustrate how far out of line pricing has become and, therefore, that further aggressive declines are necessary. National affordability is currently 17 percent below its 1992 to 2004 average, while P/I is 16 percent above its 30-year average and 34 percent above 1998 trough levels. Moreover, affordability is worst in the West (28 percent below average), we believe led by California, whose P/I is 67 percent above average. This is particularly negative for public builders, as California represents 15 percent of their 2006 closings, the largest of any state. Accordingly, without hefty income growth, we believe significant price declines–10 percent or greater–over at least the next year will be necessary to begin to approach more normal affordability levels.
Following KB Home, Lennar, and Centex's charges this quarter, which averaged 10 percent of inventory and 12 percent of equity, we expect charges for the rest of the group to average 7 percent of inventory and 8 percent of equity (as we believe the former three "under-charged" last quarter, so to speak). We expect above average 3Q2007 charges for MDC (higher exposure to today's weakest markets) and Beazer (below average charges to-date). Below average charges for D.R. Horton, Pulte, and Standard Pacific should offset their above average charges in 2Q2007. Moreover, given our outlook for further pricing pressure, we expect large charges to continue well into 2008.
Valuation Won't Help
Aside from our view that a fundamental rationale is also required to buy the group (i.e. one shouldn't buy on valuation alone), we note that at 0.79 times price-to-book value, large-cap builders are still trading above 1990's trough of 0.7 times. Also, as impairments didn't even occur last cycle for many builders, this supports the view that this cycle's trough could be even lower.
–Michael Rehaut, an executive director of JPMorgan, may be reached via e-mail at firstname.lastname@example.org. JPMorgan has an investment banking relationship with all of the companies mentioned in this column. JPMorgan or its affiliates own 1 percent or more of class common equity securities of Beazer and Standard Pacific.