Avoid the 'Resurgent' Homebuilding Sector and Go Global for Profits

By William Patalon III
Managing Editor
Money Morning/The Money Map Report

Invest in the homebuilding sector at your own risk.

U.S. homebuilders such as D.R. Horton Inc. (DRI), KB Homes (KB) and Pulte Homes Inc. (PHM) capped the sector's biggest two-day advance since August yesterday (Tuesday), thanks to a growing investor belief that the worst of the subprime-mortgage crisis has passed. On Monday - a day in which banking giants Citigroup Inc. (C) and UBS AG (UBS) released horrid third-quarter results - the Dow Jones Industrial Average surged to an all-time record above the 14,000 mark, ostensibly because investors believed the subprime mess and the accompanying global credit crisis was at least now largely defined.

But don't you believe it.

Peter Bookvar, equity strategist at Miller Tabak, is thinking along similar lines.

"You don't have a multi-year credit bubble that is over in a couple of months," Bookvar told MarketWatch.com yesterday. "Why the market thinks that is beyond me."

Market trading in the housing-and-finance-related sectors will prove us correct in the days and weeks to come.

The Fed-Fueled Crisis

This whole subprime mortgage crisis - as well as the global credit crunch that grew out of it - is part of a financial bubble or speculative mania, not unlike the "dot-bomb" crisis that derailed high-tech stocks back in 2000. Both of these bubbles grew out of the overly open monetary policies of the U.S. Federal Reserve, the same Fed that just cut interest rates by a greater-than-expected half a percentage point back on Sept. 18.

Right up to the eve of that policymaking Federal Open Market Committee (FOMC) meeting last month, Contrarian investors such as Jim Rogers were arguing that the central bank shouldn't be cutting interest rates, but should actually be raising the benchmark Federal Funds Rate. I wasn't quite so contrary: However, I did argue that the Fed should hold the line on interest rates, and that it shouldn't be looking to bail out the hedge-fund and investment-bank speculators who knew what the risks were. Nor should it be helping to bail out mid-level European lenders who had absolutely no business speculating in subprime mortgages. I mean, why a German or French bank would want to invest in the debt that consumers with lousy credit were using to buy homes in marginally justifiable transactions - and in the United States, no less - is beyond me. They deserve what they got, and don't rate a bailout.

But they got one, and that's only going to prolong the pain U.S. investors are going to experience.

If you don't believe me, just look at some past bubbles.

Bubbles, Bubbles, Toil and Troubles

During the big Internet frenzy, telecom companies (as well as many wannabes from other sectors) searched for ways to capitalize on this new medium for the masses. Scores of companies built high-speed communications networks, burying fiber-optic cable faster than Johnny Appleseed planted Golden Delicious apple trees. But the analogy is perhaps fitting, since most of those greed-fueled companies ended up eating their fiber-optic networks. Indeed, when the dot-com bubble burst and the end came, Merrill Lynch estimated that of the millions of miles of fiber-optic networks that had been built, 97.5% was "dark," or superfluous.

Thankfully, in the seven years since, such innovations as video-on-demand, streaming media, Internet Telephony, videoconferencing, and countless other inventions have helped the new landlords of those networks recoup their "pennies-on-the-dollar" purchase prices.

But tech-stock investors - especially those who were late to the party in the latter half of 1999 and the first few months of 2000 - haven't been so fortunate.

The bellwether index of that period was the Nasdaq Composite Index, which peaked in March 2000 at 5,048.62. It's not been back since, and won't reach that peak far above us for years - and maybe not for decades.

[At yesterday's close of 2,747.11, the Nasdaq is down about 2,300 points - or 46% - from its all-time high. For comparison, consider the Great Crash of 1929, and the Great Depression that followed. In researching our book, Contrarian Investing, my co-author and I found that the Dow fell from a high of 381 on Sept. 3, 1929 to a July 1932 trough of 41 - a sickening decline of 89%. The Dow didn't eclipse its 1929 high again for good until November 1954 - nearly a full 25 years later. The situation here isn't nearly so dire. But this example demonstrates just how deeply a financial crisis can wound an economy.]

I've done a lot of research on speculative bubbles and financial manias, and I've found one thing to be true time and again through history. Whenever there is a speculative mania, it's never confined to one asset class. A bubble owes its very life to the fact that it's being fueled by cheap money or easy credit. And, as the bubble inflates, it creates more of the same. Soon there's all this easy money sloshing about in the economy. Basic physics holds that water will find the easiest route to travel, and as the level of easy money rises, it overflows the confining banks of the conventional economy, and starts fueling bubbles in other areas - just as the tech-stock bubble of 1999-2000 helped fire off the housing bubble we're suffering through today.

And the fallout from that bubble won't just go away because the Fed cut interest rates once, or even twice, or because the chief executive officer of Citigroup says the banks disappointing third quarter has allowed the company to better visualize the better days to come. Here's why.

Citigroup and the Two Views of 'Normal.'

This is actually a two-part problem, right now: The housing market is in deep trouble - still - and the financial markets still haven't fully factored in the problems that are still to come.

The reason investors sent homebuilding stocks on their two-day jaunt was - at least initially - fueled by a ratings upgrade by an analyst at (of all places) Citigroup, the banking heavyweight that on Monday announced that big writedowns would cause the third-quarter profits at the No. 1 U.S. bank to plunge by 60%.

The banking giant attributed the $1.4 billion pretax writeoff to lousy mortgage investments, deteriorations in the consumer-credit markets, and debt it got stuck with because of some corporate buyout deals that went bad.

Some Wall Streeters were calling for the head of Citigroup Chairman and CEO
Charles Prince. But yesterday, Citi's "other" prince - Saudi Prince Alwaleed bin Talal Alsaud, the bank's single-biggest investor - said he was backing the current management team, even with the third-quarter "hiccup."

Even so, top Wall Street banking analyst Richard X. Bove said investors misunderstood what the Citigroup CEO meant with his reference to a "return to a normal earnings environment this quarter." If Bove is correct, the outlook is much more dour than investors currently believe.

Investors thought Prince meant that Citi would return to the level of profitability they were anticipating before the subprime mortgage problem surfaced, Punk Zeigel's Bove wrote in a note to clients. But what Prince really meant was that Citigroup and its peers are merely on a track to normal profitability, Bove wrote.

Bove took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53, The Associated Press reported.

Then there's the housing market...

Housing Bubble is Double Trouble

When I heard that homebuilder stocks were rallying, I first thought back to the fiber-optic debacle of 1999-2000. This isn't exactly the same situation, since it's not so much an overbuilding boom that we're looking at here. But it is an "over-selling" boom. Overly low interest rates created overly accessible credit.

With interest rates at abnormally low levels thanks to the rate-cutting campaign former Fed Chairman Alan Greenspan engineered to short-circuit the Asian contagion and the implosion of the Long-Term Capital Management hedge fund (see all the trouble those hedge-fund bailouts can cause?), consumers with solid credit were able to qualify for and then buy a much-larger and much-more-expensive house than they could have afforded during more normalized periods.

Then there were the consumers with poor, or undocumented, credit ratings, which fueled the subprime-mortgage market.

In short, while we didn't build too many houses during this bubble, we probably sold too many. Many deals just shouldn't have been made.

And while experts claim they suddenly have a handle on how much subprime debt is out in the market - a contention I have a tough time believing - that's far from being the only problem. Consumers who "stretched" a bit to buy a house on credit, or to buy a bigger house than they could afford, often resorted to "adjustable-rate mortgages, or ARMs. But these ARMs have an added, troublesome feature, a trigger known as "resets." The premise of a reset is simple: As interest rates rise, high-credit-risk borrowers with adjustable-rate mortgages are going to get clobbered.

Over the next few months, more than 2 million homeowners with subprime ARMs are looking at resets - and at much-higher interest rates - a reality that's likely to deepen and lengthen an already-dismal housing downturn.

More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Penna.

Even the near-term numbers don't look that good: Just yesterday (Tuesday), the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index - a forward-looking gauge of home sales - is at its lowest point since it was created in 2001.
[For our full report on this story, please click here].

Pending home sales are down 21.5% from a year ago and 22% from six months ago, according to MarketWatch.com. Even worse: Economists had been expecting the index to drop only 2.5%.

"This is absolutely awful, confirming that the existing-homes market is now in a freefall,'' Ian Shepherdson, chief U.S. economist for High Frequency Economics, wrote in a research report.

Go Global and Profit

If the U.S. housing market is going to continue to erode, so is consumer spending, which accounts for as much as 70% of all U.S. economic activity. Over the past decade, U.S. consumers have repeatedly reduced their savings from their wages until that ratio has actually turned negative. But consumers could spend more than they earned because their savings was being done for them - first by the stock market, and then by the real estate market. Indeed, some economists charge that consumers were using their homes as "virtual ATM machines," extracting cash for cars, vacations, home improvements, and other non-necessities. That's helped fuel the U.S. economic advance of the past decade or more.

But if housing prices are skidding backward, that's going to put a crimp in consumer spending. And that's going to cause new homebuilding - and the overall economy - to slow dramatically for at least the next couple of years.
Some perennially bearish investors are speaking of an even worse scenario. In a recent interview with Bloomberg TV, noted short-seller David W. Tice says that this financial mess could lead to a 40% drop in the value of the Standard & Poor's 500 Index sometime in the next 12 months. We doubt it will be that bad, but would still preach caution.

One other troublesome point that no one here in the U.S. financial markets seems to be talking about: The real estate market in Great Britain has been white hot, and is eerily reminiscent of the path the U.S. real estate market took right up until the housing market here crashed. Some experts - at least, those overseas - wonder if Great Britain isn't going to be another United States, perhaps delayed by six months, eight months, or even a year.

It makes me wonder what kind of "subprime surprise" we'll find was fuel of Great Britain's housing bubble, and subsequent collapse.

It's worth watching.

Investors who turn their attentions toward profit opportunities in the right markets overseas, as we have been advocating for some time, won't see a decline in their investment returns [If you aren't a Money Morning subscriber, please click here to receive our 6,000 word investment report: The Three Best Investments in Asia Today. It's free of charge.]

But those who continue to play "yesterday's investments" in the U.S. market run the very real risk of being left behind financially.

And none of us wants that to happen.

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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