Bubbles never end with skepticism.
Think about housing in 2006. Everyone in the world wanted to buy real estate because never went down.
Until it did.
And how about the Nasdaq in early 2000, when your grandmother and gardener both became experts on Internet stocks and told you to buy Lucent Technologies on a pullback to $75 a share, only to see the stock tumble to low single digits only a year later.
Bubbles don't end with the masses fearing an implosion; they end with people foaming at the mouth trying to get rich.
But only six years after the housing bust of 2006, there are still plenty of believers that housing is a low-risk, miracle investment. Nowhere is that showing up more than the iShares Dow Jones US Home Construction (NYSE: ITB) exchange-traded fund (ETF) linked to home builders, which has doubled since last October.
Take a look at the big gains below.
The ETF's appreciation shows the market is extremely confident that housing and real estate sectors are roaring back. But the underlying reality is quite the opposite, creating the perfect opportunity for savvy investors to make money when the housing market crashes back into its true valuation.
Another round of bad news for housing
A lot of pundits are saying the most recent read on the Case Schiller/S&P 500 House Index is signaling stability in housing, with 12 of 20 major cities showing price increases compared with last year. But that small gain pales in comparison to prices still being down 35% from their peak in 2006. A small bounce after an epic 35% fall simply doesn't sound like the warning shot for another secular bull market.
The insiders themselves are feeling bearish. The National Association of Home Builders/Wells Fargo Housing Market Index, which measures confidence among home builders, recently came in at 37, far below the level of 50 considered to be "good." Insiders are notorious for being overly confident about their business prospects, so guarded caution from this group is a signal that it's not smooth sailing quite yet.
And don't forget about interest rates. There have been some very big moves in interest rates in the past two weeks that haven't gotten much attention. A lot of short-term money flowed into riskier assets like stocks and out of treasuries and fixed-income, sending rates jumping higher. But with rates still this low, it's no wonder housing has seen a little bounce. But if that's the only thing stimulating demand, it isn't sustainable.
There's also the shadow inventory. Some estimates have unlisted or undocumented properties that are likely to go into foreclosure totaling more than 2 million, a factor that would weigh heavy on prices and any potential recovery.
If economists are right about the country's weak growth prospects for the second half of the year, then a threat of another recession would hit overvalued home builders hard. Because of all the optimism that is priced into the group despite these bearish forecasts, smart investors can still make a lot money.
Keeping these threats in mind, here are three highly overpriced home builder stocks that are ripe for profit-taking or shorting...
Although the company's $11 share price might seem like a bargain, particularly considering its all-time high of more than $82 in 2006, analysts are looking for a full-year loss of $1.00 per share. Next year is expected to improve, with full-year earnings projected at 4 cents a share.
Even then, this stock will be outrageously expensive at 275 times forward earnings.
2. Toll Brothers (NYSE: TOL)
Toll Brothers has also seen big gains in 2012, with shares also up more than 52%. But once again that march higher wasn't accompanied by similar gains in earnings. In the past 90 days, the full-year profit estimate has risen 35% to 45 cents a share, but that still leaves Toll trading at 60 times forward earnings, more than four times the industry average of 17.
3. Standard Pacific Corp (NYSE: SPF)
Standard Pacific is another home builder out of California that surged during the housing boom and then crashed back to earth.
Shares currently trade just above $6, a sharp discount from the all-time high of more than $48 in the summer of 2005. But earnings per share are still weak, with the company projected to make just 20 cents this year. This means shares trade at 31 times forward earnings, more than five times its average of six in the past 10 years.
Risks to Consider: Housing stocks are extremely responsive to any sign of good news in housing as bullish sentiment from the early 2000s remains well in play. Popular momentum stocks have also been known to trade with higher valuations for extended periods of time.
Action to Take --> Housing stocks have rallied to multi-year highs on only a marginal improvement in housing data. In the longer term, as spring seasonality washes out and the shadow inventory weighs on supply, housing stocks are set to revert back to traditional valuations for an industry that is still deep in a bear market. Investors who own housing stocks should sell them now, and those who are looking for a profitable shorting opportunity would be hard pressed to find a better looking set-up.