Homebuilders’ Stocks Haven’t Hit Bottom

10/01/2007 12:00 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says the housing meltdown is far from over and homebuilders’ stocks will fall further.

You might be thinking about taking some short-side profits in the homebuilders we love to hate: Hovnanian (NYSE: HOV) [and] D.R. Horton (NYSE: DHI). And while no one ever got hurt by closing their positions for a gain, my feeling is that you should hang in there.

Remember, the housing market has been and continues to be a mess, one that is untouched by this rate cut, and no doubt it is going to get hit again.

The issue for homebuilders is that too much inventory is meeting too few buyers—lower interest rates will not change that. Why?

Beginning in about two weeks, and proceeding for at least a year, more than half a trillion dollars in adjustable-rate mortgages will "re-set"—the interest rate on the notes will go up, in many cases dramatically, by several or more points—and these borrowers will be unable to re-finance or pay their monthly mortgages.

Why can't they refinance? Two reasons—first, the value of their homes have dropped. And when you have a 95% or 100% mortgage, you cannot re-finance without losing money that you don't have.

Second, they will not have the credit score to qualify for a new mortgage. How large is this group? In August, an industry group found that 57% of borrowers with adjustable-rate mortgages could not re-finance those mortgages—including 64% of subprime borrowers who were unable to refinance.

The same survey group said five million mortgages will re-set between now and the end of 2008. That means foreclosures.

In August, foreclosures were just shy of a quarter of a million, up 36% from July of this year and up an incredible 115% from August 2006. Assuming this rate stays constant, that means roughly three million homes will be foreclosed in the next 12 months. In fact, I estimate that the figure will be higher.

What will this do to homebuilding and housing prices? Simply put, it will kill them some more. And this [recent] cut in interest rates will not have one iota of an impact.

Radical discounts will eventually erode the book value of any company with a failing business, and there is limited demand for fire-sale homes. Other homebuilders will hold these massive sales, so ignore the hype. The value guys are gong to get sucked in and get creamed—again.

There is no telling where the book value for these companies will end up. Some will go bankrupt, probably the companies tied most tightly to the low end of the market (starter and first-upgrade homes) with big exposure to the three dying markets—California, Florida, and Nevada.

If you are counting cash and looking at buying that newly discounted Hovnanian home, don't do it yet—there are more discounts to come. Reality will sink in, more bad news will hit, and the homebuilders’ [stocks] will be ready for the next leg down. (HOV closed above $11 Friday, while DHI closed below $13—Editor.)

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