Selling into Rallies

The DJIA is up triple digits two days in a row and 3 out of the last 4 days. I am using this opportunity to sell some stocks and increase my short exposure. I just feel that the market needs one strong leg down before I can start buying long positions again.

So I have made my shopping list, which includes TAO, GAF, KOL and TKF, along with Fording Canadian Coal (FDG). I am also hoping Home Depot (HD) pulls back to $25 and Disney (DIS) to under $30 so I can start picking them up.

Home Builders have also put in a bottom and at any sign of weakness, I will look to buy Toll Brothers (TOL) and MDC Holdings (MDC).

Why do I want to buy TAO, GAF and TKF? Because the chinese real estate market is hot and second tier emerging markets in Africa and Asia present a better opportunity than the original BRIC nations. KOL and FDG – because coal is on fire and demand is increasing. FDG also has a 5% dividend to boot. HD and DIS – because they present great long-term value and are cheap!

— Faisal Laljee
Full Disclosure: I do not own any of the stocks or ETFs above but my position can change anytime without notice.

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Home Depot a Haven For Value Seekers.

Home Depot (HD) has had its share of misfortunes. It started with competition from Lowe’s (LOW) which resulted in market share losses. Then customer service issues pegged back its retail expansion. That was followed by uproar over former CEO Bob Nardelli’s pay package, which was succeeded by the housing market’s woes that caused the home improvement giant to cut its earnings and revenue guidance three times already this year. Finally, there was a bit of disappointment, first over the debate whether Home Depot’s contractor supply chain unit deal would go through, and then the value of the deal when it finally happened. And amidst all the chaos, Home Depot’s management had a hard time finding a range for the tender offer of its common shares.

But things can’t possibly get much worse. This is a company with over 2100 retail stores and $79 billion in revenues last year. And while the housing market shows no immediate signs of recovery, the stock is cheap enough to warrant a buy here.

Consider that Home Depot is still the largest home improvement retailer in the country. Moreover, the stock has taken a beating not dissimilar to that of a homebuilder. Indeed the stock sits at four-year lows at $32, and sports a P/E of around 11, which is historically a level at which the stock has found support.

Meanwhile, the company is on a path to improve in-store expertise and give existing stores a facelift to better compete with Lowe’s. More importantly, the company is in the process of a huge share buy-back, and pays a 2.7% dividend.

Home Depot is turning a corner and I strongly believe that the stock deserves to be bought here. I can’t imagine it remaining at these current levels for too long.

— Faisal Laljee
Full Disclosure: I do not own Home Depot, but my position can change anytime without notice.

Housing Still in a Rut but Homebuilders Near a Bottom

Recent stock price performance of homebuilders and those that are affected by the housing slow-down that began in late 2005 echoes the sentiment shared by many of its pundits, including top executives of many homebuilders. At a recent Real Estate Summit in New York, Larry Sorsby, executive vice president and chief financial officer of Hovnanian Enterprises (HOV) said, “08 is probably not going to be a year of strong recovery. Our hope is that it stays no worse than we are today. We’re not predicting any significant recovery”.

According to Mortgage Banker’s Association, nearly 50 mortgage lenders have folded due to the subprime crisis as part of a natural thinning of the industry. Robert Toll, Chief Executive of Toll Brothers (TOL) said at the summit, “I think there ought to be regulation of subprime. I think there ought to be regulation of prime. I don’t think that the economy is best left to its own devices almost ever. The excesses that are permitted in the mortgage industry can and perhaps have led us into a dark hole.”

The recent earnings reports from other homebuilders have reinforced this negative view. Even so, rumours of Warren Buffet buying shares of HOV led housing stocks higher on Friday on higher-than-average volume. The Dow Jones U.S. home builder index (.DJUSHB) is down about 25 percent so far this year and has lost half its value since July 2005. Currently, it sits at a key support level around 550, yet some real estate and financial pundits predict that housing stocks will remain week until interest rates start dropping.

Indeed, there is little evidence that residential real estate prices have bottomed. In Florida even with discounts of $100,000 on some homes, builders said they had realized that some developments simply would not sell and were opting to just hold onto the land for a few years in hopes of a market pickup. I recently had a conversation with a successful real estate agent in Southern California, and he summarized the market as being “terrible”. He indicated that people are not “motivated” to buy and there are way too many homes that are being listed everyday. Too many sellers, no buyers. Most real-estate agents are not as honest. They are either too ashamed or too proud to admit that business is slow.

And it seems like the government does not want the price declines either. Appraisals, even those conducted by the city, are coming in higher than what buyers are willing to pay. One reason for this could be that counties that have enjoyed the excess cash from property taxes of high priced real-estate want their coffers to stay flushed. For this reason, sellers have thrown in all sorts of incentives like a free new car, free mortgage for a year, cash back for closing costs and lots more. But these $20,000 to $30,000 incentives pale in comparison to the prices still being demanded by sellers. The dichotomy between rental rates and mortgage rates for the same property is too huge and the gap needs to narrow before we can see home prices stabilize.

On the other hand, stock prices of home builders usually run six months ahead of any long-term trend changes. For instance, the home builder index mentioned above peaked in July even as home prices were going up in states like Florida and California. If you are looking to invest in the homebuilders, I believe its time to start picking away at some of the better ones. I recommended MDC Holdings back in September of last year. Since then the stock has been up as much as 30% before pulling back to a gain of 10% as of last week. Some other ones that are worth buying on dips are Hovnanian (HOV), Standard Pacific (SPF), MDC Holdings (MDC), KB Home (KBH) and DR Horton (DHI). Just keep in mind that investing in home builders will require patience and a stomach to sustain a little loss for a few months.

— Faisal Laljee
Full Disclosure: I do not own any of the stocks mentioned here but this can change anytime without notice.

Should Regulators Have Their Way with Mortgage Lenders?

As if there isn’t enough talk of the sub-prime mortgage business already out there, here is another post concerning the subject. Why is this post different than some of the others? For one, living in Los Angeles means I have some friends in the mortgage arena so I know a thing or two about the business, and for another, the investor side of me presents the other side of the coin.

So whats the problem in sub-prime? To understand that better, lets start with what is sub-prime. Every lender has a different criteria for sub-prime but mainly, people with Poor to Good credit are considered sub-prime. Usually, this translates to a FICO or a box score of between 500 and 700. Some lenders have prime mortgage products for those that have a credit score of 640-700, but for the most part, this area is considered Alt A, which means prime product for a sub-prime borrower. For a business, sub-prime loans are risky in that they have a higher tendency to default, however, these loans have higher profit margins.

Companies like Ameriquest and New Century (NEW) have made a lot of money over the recent years taking advantage of the housing boom by lending to riskier consumers and making the higher margins. When consumers were not able to afford the monthly payment, they offered Negatively Ammortized loans, 120% loans and other such irresponsible loans against Stated Income without any regard to the long term impact of these to the borrower, the industry and the government.

From 1998 to 2005 when the residential real estate market was expanding by leaps and bounds and property values appreciated as much as 30% annually in some markets, sub-prime borrowers who bought a house enjoyed their home equity by refinancing multiple times in a year to get cash and either pay off their higher interest credit cards or finance their home improvements and/or other purchases. Lower rates meant their payments were stable even as their borrowed loan amount increased. It really was a rosy picture.

Did you know that over the last 50 years, the average annualized gain in the housing market has been 3%? Compare this to the double digit gain over the last 10 years and it is no surprise that housing has not been an investment vehicle until recently.

So why is there a problem now? I don’t believe the problem is sub-prime specific. After all someone who has a score of 710 and qualifies for a prime loan can easily slip to 690 within months. In fact, prime ARM delinququencies are at 6 years highs, whereas fixed rate sub-prime mortgages are well below their higheest levels. So regardless of who you are on the credit spectrum, the increasing interest rates since 2005, declining property values since 2006 and the expiring ARMS (adjustable rate mortgages) has impacted borrowers. ARM payments have jumped anywhere from 10% to 50%. There is no more equity left in their home since they refinanced at higher prices, which have since declined. Loan to Value ratios for many such borrowers is over 100%. This means the banks own their homes and the borrowers still owe these banks money on top of that.

You have a consumer who makes average income, lives beyond his means, has used up every ounce of his home equity to finance items he couldn’t have afforded otherwise and now he is looking at an increased monthly payment, higher rates on his credit cards resulting in higher minimum monthly payments to creditors, and a home that is worth less than the amount he has borrowed to finance it. All this against flat to slightly higher wages. This situation is compounded in states like California whether median home value as of 2005 is $524,000. Such mortgages run around $2500 per month these days even for people with excellent credit. Considering property taxes, home owner’s association, gas prices, car payments and other expenses, such a person needs to make $100,000 a year before taxes ($6000 per month after taxes). Median income before taxes in California is $49,894 as of 2005 according to the US Census Bureau. This means that most people cannot afford the house they live in. While California is an extreme example, other states are not too far behind.

Who is at fault? It is partly the lenders and partly the borrowers. That is the general consensus, but I think the government should have stepped in a while back. Alarms had been raised time and again about the looming disaster that has finally hit us today.

The lenders are at fault for lending to borrowers who could have been identified as being high risk. But then lenders are in the business of making money even if its at the expense of the consumer. Or are they? If they are public companies then yes, their primary obligation is to their investors. When rates went up these lenders loosened their underwriting standards to attract a shrinking pool of borrowers instead of tightening in the face of lower home values.

The borrowers are at fault for being over-extended. Greed for cash in the face of rising property values got the better of them and they kept spending borrowed money even as incomes didn’t rise.

Government is at fault for not taking action earlier. By generalizing across the country, I am being unfair to some states who have adopted aggressive policies to protect home owners. Let me clarify that I believe this is a Federal matter and as such individual states should not be entirely responsible.

So what action could the federal government have taken? More importantly, should they regulate the mortgage business? After all, they regulate banks and most of the banks have a mortgage division.

The answer is yes. Mortgage lenders should be regulated somewhat. Certain strict underwriting criteria should be enforced on all lenders so those borrowers who cannot meet this criteria cannot borrow. Additionally there should be a cap on how much can be borrowed. This cap can be based on past income, current income and current debt. Unlike existing rules, only documented income (in the form of taxes and pay stubs) should be counted. Retirement accounts, savings and investments should also play a role but should not be categorized as income. These are safety nests and should be treated as such. Most lenders have these underwriting criteria but they are self regulated and often bend the rules to get these loans approved. New Century is a prime example. The Office of Thrift and Supervision that regulates banks should have a separate division to handle non-bank lenders. Can you think of other ways to regulate this industry or are you in the non-regulatory camp?

— Faisal Laljee

Will the Sub-Prime Mortgage Issues Have an Adverse Impact on the Markets

This is a question that most investors are pondering, including myself. Will Sub-Prime Mortgage Issues Impact our Financial Markets in a Way not seen since the Enron scandal? While I am not sure of the answer, here is my point of view.

It all started with HSBC warning of higher delinquincies in their mortgage business and was quickly followed by New Century (NEW) announcing that they would not make a profit for the foreseeable future. All that now seems so far away. Making a profit is the least of New Century’s worries as higher delinquincies and controversial lending has prompted an investigation into its business, not to mention that the company’s almost $3 billion market cap has been wiped out.

Last week, Countrywide (CFC) stopped offering 100% financing. Option One and some others followed suit. If this tightening flow through to other areas of the finance spectrum, with auto makers and credit cards, it could spell the end of the fierce consumer spending seen in the US these last few years. What are the chances though that credit cards will tightening their lending guidelines too?

If the above does indeed happen, it will affect equity markets in a big way. We are a nation that operates on credit a little too freely and putting additional boundaries on credit cards for sub-prime audiences would result in a huge slow down in the economy. Retailers would be impacted the worst in this scenario. But if the above does not happen, is the Mortgage business alone capable of bringing the consumer to his knees? Default and foreclosures would mean people would have to go back to renting a more affordable place. This would result in property values declining somewhat (which they already have with room for some more declines), which in turn would mean the end of home equity for most home owners, which would slow consumer spending somewhat. It would also mean consumers would then rely more heavily on credit cards. Its an unenviable situation no matter which way you look at it.

What does this mean for the stock market? On most days, it seems the market operates more on psychology and less on fundamentals. A slowing consumer spending cycle would translate in a slowing economy, which would mean the S&P 500 companies might post smaller than expected gains in the upcoming years.

While the above scenario sounds extreme, it is not unlikely. So where do big investors like the hedge funds put their money? Corporate bonds? Give me a break! These guys expect to grow their money at 20% annually. They would invest in the stock market or invest against it by shorting it. Other wealthy investors who were previously picking up real estate now need to put their money elsewhere. They will look to mutual funds. And what about private equity? They are constantly looking for companies to buy, taking away some of the supply from the financial markets. These opposing forces make it confusing for the average investor.

A friend of mine asked me yesterday the very same question that graces the title of this post. And my answer to him was that I am short term bearish but long term bullish. A fat lot of good that did him. That answer was neither here nor there and I know that. The above circumstances are truly unique. There are just as many positives in the market as there are negatives. I am leaning more on the negative side until we see the fall out from the Sub-Prime Mortgage issue. If this turns into a “scandal” we have a problem. I am open to your thoughts on the subject.

— Faisal Laljee