Michael Santoli

To Play a Market Dip, Leave Homebuilders, Ride the Rails

Michael Santoli

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The only real reason the lazy little market pullback early Monday merits notice at all is that it came after eight straight winning trading sessions and as the broad indexes were pushing against all-time highs. That, and the fact that the very same calm, clockwork ascent of recent weeks has so many traders and investors expecting, and even pleading for, a pullback -- either to buy at more comfortable prices or capture some overdue downside returns.

Whether this shallow sag in the Standard & Poor's 500 index -- of no more than 0.4% so far -- builds into that much-awaited correction is impossible to say. Yes, in the short term stocks seem overstretched, bullish sentiment is percolating and the market strength is gaining the attention of the non-financial media, just as some high-stakes economic data will arrive this week.

Even a sharp and sudden pullback (the most common kind) probably wouldn't be an important market top, though, given sturdy credit conditions and plausibly bullish fundamentals. It's not likely that the market gods are quite so perverse and spiteful as to deny the S&P 500 the 5% more it needs for a new all-time high by putting it all asunder just as the public is waking up to the reality of the four-year bull market.

All that said, the market's stutter-step offered some clues of what areas might be most vulnerable should the pace of selling pick up. No big surprise, some of the recent leaders benefiting from swelling optimism toward housing and the global cyclical acceleration story were suffering some profit-taking.

These include the stuff of China's global forge, coal and steel. The Market Vectors Coal ETF (KOL) slid nearly 1%, and the Market Vectors Steel ETF (SLX), almost 2%. The latter was absorbing a downgrade of the steel group by Goldman Sachs. The cautious call and resulting selling is understandable, given the recovery hopes already priced into the stocks. But in a bigger-picture sense, Wall Street's pushing back against the rebounding cyclicals is a healthier pattern than seeing analysts chase the trend.

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The railroad stocks have pulled the Dow Jones Transportation Average to a new all-time high in recent days. The iShares Dow Jones Transportation Average ETF (IYT) gained 20% in the past 10 weeks, a blistering pace for such a hefty segment of the market.

Investors coveting the rail stocks should probably welcome a retreat in their prices. They are still reasonably valued based on forward earnings prospects, and so far China's leading manufacturing indicators are sending reassuring signals about demand for raw materials and global trade.

(Interestingly, Warren Buffett's Berkshire Hathaway Inc. (BRK-A, BRK-B) these days trades more like a train stock than anything else, owing to its Burlington Northern railroad division acting as the its biggest source of profits and most of Berkshire's cyclical exposure. Any serious selling in Berkshire based on a cooling railroad sector would be a gift to investors looking to grab this unrivaled collection of assets at an even slimmer premium to book value than it currently commands.)

The pure homebuilder stocks, on the other hand, deserve to surrender even more of their recent gains, and at recent share prices offer a poor risk-reward bargain for long-term holders. The SPDR S&P Homebuilder ETF (XHB) peaked above 46 weeks after it debuted near the height of the home-price bubble in early 2006. It crashed more than 80%, then bottomed near 8 in the March 2009 market abyss. It has since surged above 29, including more than a 50% gain in the past year. So, the builders are trading at almost two-thirds the peak value reached at the most blissful moment of the greatest speculative house-buying mania we will (hopefully) ever witness.

Make no mistake, housing in general has embarked on a durable, long-lasting recovery, one that will remedy a severe degree of under-building and depressed housing demand in recent years. The current pace of 900,000 housing starts is still radically below the 1.5 million pace needed to properly replenish the housing stock. The U.S. economy and consumers will feel a tailwind from this activity for a long while.

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Trouble is, the valuations of homebuilder stocks already seem to price in most of the likely good news of the coming years. The major house-building names - D.R. Horton Inc. (DHI), Lennar Corp. (LEN), MDC Holdings (MDC), PulteGroup Inc. (PHM) and Toll Brothers Inc. (TOL) - each fetch between two- and three-times book value.

Book value tends to be the best guide for valuing these stocks over a cycle. And yes, book values are now depressed and could understate future tax-loss assets the builders can deploy against future profits. Yet buying the stocks at large premiums to book is rarely a winning long-term strategy.

While the stocks may remain in favor as the housing rebound story gains resonance, few investors recognize that the builders are not especially good businesses. They are mid-cap, mostly regional companies with no real sustainable competitive advantage, few economies of scale and little control over their product pricing or expenses. To grow, they need to buy more land, which gets more expensive as demand for their goods improve, as does lumber and labor. Once the market has given them credit for improving fundamentals, there's little reason to consider paying up for the stocks - until the next bust.

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