New Home Sales Slingshot to the Upside for Now

The Commerce Department released data for new home sales in March that were stronger than economists had anticipated. Sales climbed 27% to an annual rate of 411,000, and it marked the most rapid surge since April of 1963. These strong results followed an unexpectedly weak reading from February; a record-low annual pace of 324,000 (originally reported as 308,000 but since revised upward). New home sales are clearly benefitting from buyers looking to take advantage of the final weeks of the $8000 new home-buyer tax credit scheduled to expire at the end of April.

Demand may remain elevated through this month as Americans take advantage of a tax credit worth as much as $8,000 before it ends at the end of next week. The outlook for the rest of the year hinges on sustained job gains as homebuilders struggle against a wave of foreclosures that is depressing home prices and adding to inventory.

“We’ll probably see another jump in April and then we’ll get some payback in May and June,” said Jim O’Sullivan, global chief economist at MF Global Ltd. in New York. “Through the volatility, the trend in home sales is probably more up than down.” – Bloomberg.com 4/23/2010

Not surprisingly, residential construction stocks have ratcheted higher on the news led by Hovnanian Enterprises (HOV) and PulteGroup (PHM), although both have come down slightly from intraday highs. Better weather, the tax credit and growing consumer confidence provided a nice tailwind for the housing market in March. The trends are certainly improving for homebuilders as the market stabilizes, but we continue to view homebuilder stocks are among the fundamentally weakest in the market. We believe the fact that these stocks have appreciated so greatly over the last year is due to the fact that they were so badly beaten down, rather than a correspondent strengthening of underlying fundamentals. For that reason, the majority of the stocks we cover in the residential construction segment are currently Overvalued by our methodology, and fundamentals will need to improve drastically in order to justify today’s prices.

The stock market should react when data comes in better than anticipated, and that is what we are seeing today. However, the market must also be forward looking, and in that case the outlook for housing remains unclear. Continued signs of general economic recovery would certainly prove beneficial to the housing market as jobs are created, foreclosure rates slow, and confidence is restored. However, there remains the problem of large amount of inventory remaining on the market. The National Association of Realtors estimates that there is a supply of 3.58 million homes currently available for sale, which equates to about 8 months worth of supply. This is a slight improvement from previous reports, yet as the market improves banks may start listing more of their foreclosed properties. This “shadow inventory” is clearly an unknown and may serve to keep inventory levels high for a prolonged period of time. Excess inventory is the enemy of home-builders, as it means adding to the supply (their business) would only serve to further misalign supply and demand, in time lowering prices.

For homebuilders, losses have been trimmed recently and there has been necessary consolidation in the industry already. However, the next few months will be pivotal for these stocks. The expiration of the tax-credit may lead to a lag in purchases for the following months, and any rebound in prices may bring out some housing inventory hiding in the shadows of big bank balance sheets. From a value investor’s perspective, we recommend staying away from stocks heavily tied to residential construction, in spite of today’s bullish data.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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