Tuesday, July 28, 2009
Email – #487
** No Place Like Home?
Over the past few weeks there has been a noticeable trend in housing. This trend seems to indicate that the housing market is approaching a bottom, where prices are stabilizing and inventories are decreasing. Personally, I think that the housing crisis – while far from over – is reaching a point at which buyers are beginning to step in and make offers for properties.
These offers may not be what sellers want to see, but it is a far cry from the darker days of late 2008 when any offer was hard to come by.
Interest rates are low and that is also helping to spur activity. The housing market is however notoriously fickle. In order for it to truly recover, we need to see more inventory move off the books.
Historically the housing vacancy rate in the United States has been around 1.5%. It is currently more than 2.5%, levels associated with major recessionary times. But, if the numbers keep showing a positive trend in sales, regardless of prices, then reduction in inventory will follow.
There is already evidence that in some parts of the country prices are beginning to stabilize to the point that monthly median prices are falling by less than 2% as opposed to the double digit falls that we were seeing. And, if foreclosure mitigation (read government subsidized bailouts to banks holding toxic mortgages) kicks in, then that will also alleviate some pressure.
The credit for new homebuyers is helping as well. Mortgages for new homebuyers are tougher to qualify for, as they should be, but refinancing activity is booming as evidenced by the results from the financial institutions that have just reported numbers.
Furthermore, my conversations with a mid-size prime lender, a long time friend, also indicate that mortgage activity is quite strong. In fact, at this time last year he employed less than 500 people in his mortgage lending department. That number today is over 1,300.
A Winning Strategy
So, how do we play this potential upturn in housing while still paying heed to a possible stall if the economy doesn’t recover in the next few quarters?
Remember, we don’t need a recovery for stocks to move higher, just the signs of one. The market in general looks a little overextended right now so we must take that into account as well, as a technical correction is quite probable in the weeks ahead.
The only way that I know how to achieve all the goals I’m looking… something that is able to win if housing has bottoms, yet also protects myself in case it hasn’t (or just in case the market takes a nasty fall in the short term)… is to continue with strangle plays that work both sides.
As we have seen recently, our Bank of America and Manitowoc strangles are doing exactly what they should be doing as the underlying shares rise and fall. The recent run-up in BAC has been beneficial to our calls, but not enough for us to take profits yet and cover our initial cost of the trade.
Up until yesterday when MTW reported earnings, the shares were heading higher nicely. The company, while reporting poor numbers as expected, did show glimmers of hope for the coming quarters, and they also paid a small dividend to shareholders. We have 18 months left on both plays, so there is no need to get impatient. If the market does correct before heading higher, we will close out our put positions.
How We’ll Play It This Time
So back to the business of homes. We will engage in a strangle on Pulte Homes (NYSE: PHM), one of the few high volume homebuilders left in the market today. It recently agreed with Centex, another larger builder to merge operations as a way to weather the storm by reducing redundancies.
On a positive note, Pulte insiders have been buying shares aggressively as well. It has a good debt to equity profile, for a homebuilder, and a pile of cash. Most of its debt is against land that it owns for development, which it has been writing down as the economy and housing market worsened.
Our play on Pulte will be to buy the January 2011 $7.50 PUT LEAPS (OPN MU) currently trading for $1.60 on the offer, and to buy the January 2011 $15 CALL LEAPS (OPN AC), trading at $1.85.
The current share price is $10.57.
What we are looking for here is for a recovery in the housing sector by the end of this year. This means better inventory numbers in coming months and a stabilization in the median prices.
If we have another couple of months of upward trending numbers, shares could easily reach the $15 level by fall. If the market corrects in the meantime, we will see a pullback that could take the shares down below the $8 level. The best case scenario is to have a correction followed by a recovery which may enable us to profit from both sides of the trade.
Do not pay more than $1.70 for the for the PUT LEAPS or more than $1.90 for the CALL LEAPS. There is plenty of liquidity in the options and you should have no trouble getting filled if you are patient.
Karim