A Pairs Trade: Mortgage Lending vs. Homebuilders
by Graham Summers
August 9, 2006
From 2001 to April 2005, 43% of all new private sector jobs were related to housing.
In other words, if someone you know got a new job during that time period, the chances of it involving the housing industry were nearly that of a coin toss.
Both sides of the home sector - homebuilders and mortgage lending - were making obscene amounts of money. Pulte Homes (PHM) the $8.5 billion 800-lb gorilla of homebuilders saw annual revenues increase an average of 28% four years straight.
Meanwhile, its cousin in the sub-prime mortgage lending sector, Countrywide Financial (CFC), saw revenues increase annually by an average 43% for the same time period.
In June 2004, the Federal Reserve began to raise interest rates. And while any interest rate hike would have negative consequences on these businesses, it wasn’t until mid-year 2005 that the full effect of the Fed’s agenda began to take hold.
Strangely, while it brutalized the homebuilders (Pulte is down 33% in the last 12 months), the sub-prime lending segment only received a light beating (Countrywide is down 13% in the last 12 months).
Homebuilder stocks are now trading at or near their 52-week lows, while the mortgage lenders hover close to their 52-week highs. We’re essentially seeing the tangible side of the sector killed while the financials side stands strong.
However, this trend can’t last much longer. The cracks in the homebuilder market have begun to show up in 2Q06 results for the mortgage markets as well. According to DataQuick, a real estate research firm, defaults on mortgage payments hit a three-year high in California for 2Q06, rising 67% from the year before.
Countrywide’s 2Q06 profit margins on its mortgage origination business have more than halved in the last three years, falling from 1.03% in 2003 to 0.31% in 2Q06.
Popular with Wall Street, the sub-prime lending sector is ripe for some short plays.
Meanwhile, large cap homebuilder stocks such as Pulte, DR Horton, Centex, and Lennar are at their cheapest levels in years. All four of these multi-billion companies are currently trading at single earnings multiples. They’re dirt cheap, and unpopular on Wall Street.
And they’re just beginning an uptrend. Having bottomed out in July, all four of these stocks recently rallied above their 50-day moving averages. The momentum is building here.
For a safe way to play these sectors, consider a pairs trade shorting sub-prime mortgage lender stocks and going long homebuilders.
Good trading
Graham |
