Is the Real Estate Market Ready to Rally?

When homebuilding stocks peaked in the summer of 2005, the real estate market was flying high and discussions of how to make a fortune flipping properties had become a staple. Few at the time had any idea that the industry's best days, possibly for years to come, were now behind it.

Housing Highs and Lows

After rising from a new millennium low of $7.90 in February 2000, the VectorVest Builders Index consisting of 26 homebuilders (residential and commercial) experienced a meteoric rise hitting a high of $83.24 on July 29, 2005. That’s a gain of 1000% in a little more than 5 years. Those who joined the rally early made off like bandits. (For the list of builders in the VectorVest Builders Index, visit www.VectorVest.com/builders.)

But then signs emerged that the rally was waning. Following its July high, the index put in a series of lower highs in the first 4 months of 2006 and then fell until July 2006. After a bear rally that persisted into February 2007, the index again began to drop toward $50, weighted down in part by the general market melt that began on February 27, 2007.

Talking Heads Disconnected

Between 2005 and March 2007, often when negative housing news hit the press, market analysts and real estate cheerleaders said the worst for real estate was behind us. But each time, the market told a different story. What kept these analysts so housing happy in the face of falling stock and housing prices?

In a word, it's the fundamentals. There wasn't a hint of trouble in earnings until August 2006, when earnings growth began to plummet—long after the VectorVest Builders Index broke the long-term uptrend support in May. But when earnings did begin to drop, they dropped fast. By mid-December, earnings growth had turned negative for the first time since 1995.

This demonstrates a key pillar of market analytics that the fundamentalists miss. Stock price is the best leading market indicator. Using earnings or other corporate fundamental metrics to anticipate where price is headed is like waiting for the gun to go off before ducking. That being said, once a stock rally has begun, if it’s not followed by improving fundamentals, it can’t last.

What's in store for homebuilders? First, the trend must change direction. As a gauge you can use the streetTracks Homebuilders Standard & Poor’s Depositary Receipt (XHB) exchange-traded fund as a proxy. The latest rally came to an end on February 26 and another downtrend began. To know when it is over, watch for a new series of higher lows and higher highs in price.

What stocks will do best in the next rally? Look for the leaders in the pack. Right now that would be NVR Inc (NVR) and Mexican builder Homex Development (HXM), the two top-rated companies in the VectorVest Builders Index, but they won't necessarily be leaders when the dust settles. Whenever the worst for homebuilders is over, the trend will tell you. Then it’s a matter of either playing the industry with an exchangetraded fund or choosing the leaders in the industry to give you the best chance of winning the bottom picking game. When the fundamentals turn up too, you’ll have further confirmation that you’re on the right track. Matt Blackman hosts TradeSystemGuru.com, a new Web site that evaluates tools for traders and investors. Blackman is a technical trader, keynote speaker, and regular contributor to a number of major trading publications and newsletters. He welcomes questions or comments at matt@tradesystemguru.com.