What Relative Strength Says About Homebuilders

Homebuilder stocks clearly earned the “Biggest Loser” title during the five years that followed the 2006 peak in U.S. home prices.

Between April 2006 and January 2012, the Case/Shiller Home Price Index lost just shy of 34%. And while the average homeowner lost money as the value of their largest investment sank rapidly, investors in homebuilders’ stocks lost even more.

PulteGroup (PHM) lost a full 93% of its market value between July 2005 (peaking at $48.22) and October 2011 (in “penny stock” territory at a low of $3.29).

That all changed in 2012.

The Case/Shiller index bottomed in January and PulteGroup’s stock price shot more than five times higher. The question now is, “will it last?”

Harry and Rodney’s research strongly supports the forecast that home prices will take another leg down before a true “bottom” is put in. This is based on many years’ worth of financial data that shows asset prices always return to pre-bubble levels following a bust. This portends a further 20% to 30% decline in home prices.

The thing is, you cannot always draw a direct correlation between the direction of home prices and the direction of stock prices of homebuilders.

After all, builders have cut costs to the bone and reorganized to align with the new normal. These moves eventually paid off in 2012 as their financials grew stronger and their stock prices soared.

What’s more, relative strength analysis suggests PulteGroup will earn above-average returns over the next year. I reached this conclusion after delving into research that Robert Levy, Ph.D., Narasimhan Jegadeesh and Sheridan Titman did.

Their research, published in the Journal of Finance, basically shows that strong stocks stay strong for a predictable period of time. Here’s a bit of empirical evidence supporting their claim…

Jegadeesh and Titman calculated the six-month percentage change of all stocks and ranked them in order, from strongest to weakest. They then took the top 10% of outperforming stocks and tracked their performance over the next several years. Their analysis showed these top 10% stocks earned on average 1% more, each month, than the market’s average. This momentum of outperformance was shown to persist for three to ten months following the ranking.

Using the same six-month percentage change in stock price, I ranked stocks at the end of October. Can you guess which stock came out on top?

It was PulteGroup. It had the market’s highest six-month change of +76.22%.

Now, just because PulteGroup shows promise for outperforming the market over the next year, that doesn’t mean today is the perfect time to buy. Here’s a chart of PHM showing its record 2012 performance and a suggested buy zone.

See larger image

Amidst a broad market correction, PulteGroup formed a bearish pattern last week – the ominous “bearish engulfing candle.” Expect a pullback to at least $14 and possibly lower. Buying PHM between $12.50 and $14 is a much better bet than getting in today.

But remember, believing PulteGroup’s stock price will rise does NOT mean the housing market is beginning to recover. As far as we’re concerned, the housing bust still has a long way to go. That doesn’t mean you can’t ride homebuilders’ 2012 momentum to make some money.

If you haven’t done so already read the Survive & Prosper issue on “The Hallmark of Deflation

 

 

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Categories: Economy

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.