Thursday, April 14, 2005

Stock Market Suggests that Homebuilders on Extremely Thin Ice

The position of the homebuilding stocks is reminiscent of the jolly red bear in the kids’ game, “Don’t Break the Ice”. The homebuilder stocks sit complacent, atop a foundation of supporting sectors (or “ice cubes”) that are being knocked out from under on a daily basis. As each “cube” cracks, the position of these stocks becomes more and more tenuous. When the jolly homebuilder bear finally loses his support, his fall is likely to be fast and far. Tonight, I will examine several of the falling sectors as well as some that are being displaced. How long can the jolly homebuilder bear hang on? Some key charts say not much longer.

I recently scanned Investor Business Daily’s (IBD) list of 197 Industry group rankings, identifying all sectors that supported the US housing market. This scan is presented in the chart below which indicates sector rank in stock performance over the last 6 months (from 1- best, to 297 - worst), versus the ranking 3-months ago.

Thin Ice – Housing-Related Stock Performance Lagging Badly

Housing-Related Sector (Data from IBD
8 April 2005)

Sector Rank (stock performance over the last 6-months)

Rank 3 Months Ago (stock performance over the last 6- months)

Gain (Loss) in Rank versus 3-months ago.

Mortgage and Related Services




Household – Appliances




Savings and Loan (similar performance in other banks too)




Building Paint and Allied




Building Wood Products




Household and Office Furniture




Building Cement, Concrete and Aggregate




Building Construction Products Misc.




Building –Residential




The chart above clearly illustrates that the housing-related sector stocks are either presently ranked in the last quartile, or falling significantly in rank, or both. While the homebuilders presently rank in the top 8% of sectors in 6-month performance, all supporting sectors are failing to confirm the bullish performance. In my view, it is telling that the sector consisting of mortgage and mortgage related services is presently ranked dead last of all 197 groups after having dropped 108 places over the last three months. While conditions in the homebuilder sector were so favorable for so long that these stocks were going up universally, it is ominous that on Friday a small and lagging homebuilder, Dominion Homes, made a fresh new 52-week price low. Note Dominion Home’s 2003 sharp rise from below 15 to just under 40 in less than one year concurrent with all other homebuilders. Yet a rising tide no longer lifts all boats and this, it seems to me, is signaling that the end of the homebuilder stock bull market is almost upon us.

The most ominous aspect of the housing-related stocks is the ugly action in the mortgage related stocks, ranking dead last of all 197 IBD-categorized groups. We have all heard and are familiar with the action in pseudo-government related entities, Fannie Mae and Freddy Mac, yet in many cases, the less popular and/or completely private mortgage companies are telling an even more bearish story that is illustrated in the charts below.

They are all exhibiting bearish chart patterns which suggest that something is just not right in the business of home finance. These stocks generally can be shorted provided that appropriate entry points and stops are used.

Time to Call an Audible

While I had intended to illustrate more sectors and charts tonight, unfortunately, my high speed internet connection has been on the fritz and I cannot bring up the excellent charting service, Instead, with several sectors of the stock market appearing to be ripe for short sales, it may be appropriate to review an important concept in technical analysis – the head and shoulders (HAS) reversal pattern. This is a pattern that has appeared throughout the recent bull market, but has rarely run to completion all the way to the final trend reversal from UP to DOWN. Since October 2002, the typical behavior has been HAS formation followed by what appeared to be a neckline break. But in practically all cases, this apparent neckline break turned out to be a whipsaw into a sharp and tradable bullish rally. In essence, these pattern failures were telling us something about the general conditions of the stock market – that the environment was still bullish or at least neutral, but not bearish. However, in recent weeks, the appearance of neckline breaks of support (and no bullish whipsaw) in certain sectors such as auto parts and mortgage companies may be signaling a bearish change in general conditions of the stock market. The 6-week-old annotated chart of Redwood Trust (RWT) below, provides a good example of this. Although a head and shoulders pattern formed and appeared to break to the downside in late February, anyone going short at the neckline breakout got punished due to still bullish general market conditions. Yet as of today, the RWT neckline has been broken and RWT is now in an established downtrend (not shown).

The apparent new character of general market conditions must be considered from a tactical perspective. The following four factors need to be addressed in selecting an entry point for shorting into an identified HAS reversal pattern:

  1. The technical pattern must suggest that there is significant gain to be made by taking a position.

  2. There must be evidence that the technical pattern has been completed and that probability suggests the trend has reversed.

  3. An appropriate price must be established that would indicate the “improbable” is occurring, and a small loss must be taken on your part.

  4. A good risk/reward ratio between the potential gain (#1), and “improbable” small loss (#3) must exist.

As this applies to the HAS reversal, the most logical price in which to enter a short position is after several days have passed after the apparent neckline break has occurred and a bullish whipsaw has not occurred. This is because failure of the HAS patterns have tended to occur right after the apparent neckline break with a sharp break to the upside, on relatively high volume. Although there have been a few “breakouts” to the downside that have “worked,” the preponderance of whipsaw rallies have outnumbered the downside “breakouts” by a wide margin. For this reason, a rally back to the neckline, on low volume represents a lower risk point in which to enter a short position on a HAS reversal. This strategy results in an ideal low risk stop out point if the “improbable” occurs – a decisive close above the neckline. In the case of Dominion Homes in the chart above, a low volume rally back to 19 would present a good risk/reward ratio to enter a short. (That is, if you can be assured that a larger homebuilder won’t buy them out for $30/share in overpriced stock! This is a chart example – not a recommendation).

A Final Note on “Don’t Break the Ice”

Since my two daughters are 9-1/2 years apart in age, I owned this game at two separate times. The ‘80's version of “Don’t Break the Ice” had a scared looking man sitting on a chair with a fearful expression and tight grip on the chair that was placed on the “ice.” By the late ‘90’s the scared man was replaced with a jolly looking smiling bear on ice skates. While a case for the ‘80's version of the game, depicting what could be construed to be too sadistic, I’m afraid today’s jolly ice skating bear is too complacent.

Today’s Market

It was an ugly day and an ugly couple of weeks in the stock market regardless of where you were invested from the long side. The Dow Industrials were down 1.2%, the S&P 500 down 1%, the Nasdaq down 1.4%, the transportation index down 3%(!), the S&P Mid Caps down 1.84%, the Russell 2000 down 1.76%, and the NYSE composite down 1%. Gold was down $5.80 ($423.50/oz), while silver was down $0.16 (%7.06/oz), and the XAU and HUI were down 3.3% and 4.2%, respectively. Oil caught a slight bid finishing up 0.65 at $52.78, right about at its 50-day moving average. The rally in bonds continued as it broke what appeared to be resistance as shown in the chart below.

Gold and the dollar are at critical crossroads – gold is right on its upward trendline, and the dollar is right on resistance.

The gold and silver stock traders didn’t wait for these trends to be broken before selling as indicated by the HUI and XAU swoon.

Summarizing the action in the financial markets since about 1 month ago, I come up with the following:

  • Bonds Up

  • Dollar Up

  • Japanese Stocks Down

  • US Stocks Down

  • Industrial Stocks Down

  • Financial Stocks Down

  • Transportation Stocks Down (!)

  • Commodities Down (Oil Down)

  • Gold Down

If these are in fact, actual trends and not statistical and speculative “noise,” then the evidence suggests deflation. Should we lambaste those astute analysts who are of the inflationary school of thought? Being a humble chart reader, I would only suggest that trying to call the inflation or deflation scenario is like predicting whether Apollo 13 was going to crash to earth or careen out into space. Yes, the ship landed safely via extraordinarily skilled professionals in their prime and working at their best under pressure. So, similar to that situation, our economic “ship” may be able to land safely. To believe this requires that you also believe those officials making the critical economic decisions are extraordinarily skilled professionals, in their prime, and working at their best under pressure.

Since we started this article talking about head and shoulders reversals and homebuilders, it is apropos that we finish on this topic. Below is a 3-month hourly chart of the Dow Jones US Home Construction Index.

Note that the neckline has been decisively broken today with a downward move of over 4% on very heavy volume (not shown). If it doesn’t whipsaw back above the neckline soon (fast and tradable), the initial price objective would be about 725 to the downside. Today’s action in the homebuilders occurred in spite of a rallying bond market. It looks like the housing bubble is bursting right before our eyes. What would cause a rally back to the neckline? Fed speak about DE-flation and indications that the raisings of the Fed funds rate can be slowed, measured more, stopped completely, you get the idea.

Stick around; this could get interesting!