Reasonably Thinking

My broker failed to maintain adequate inventory of ITB shares today, so I was forced to cover my ITB short position by 200 shares, at $13.84.  I replenished this position by purchasing three ITB 17.50 Jul10 Put options at $3.90; these are options that I have purchased before.  Even though I am down somewhat significantly on this trade, I remain steadfast that housing is overvalued, as evidenced by my continued financial backing.

A decline in housing remains one of my strongest investment ideas.  Let’s walk through the thought process…

Congress is subsidizing housing demand via its first-time homebuyer tax credit.  This pulls forward future demand.  When the program ends, demand starts to dwindle (and will fall to an even lower amount than what normally would have occured).  If Congress extends this subsidy, which happened last fall, even more demand will be pulled forward, and the fall will be even greater.  This ongoing game of taxing people to subsidize home ownership has consequences as demand cannot be artificially inflated forever.  Housing demand will decline.

A simple rule of economics:  when demand declines, prices fall.

 The second part of the equation is the onslaught of delinquencies and foreclosures coming onto the market.  Reasonably thinking, with an enormous amount of houses soon to be available for sale, constructing even more houses is not a good business to be in.

Another simple rule of economics:  when supply increases, prices fall.

The trade:  bought 2 ITB July put options at strike $17.50, for $4.50 each.  The breakeven is about $13, and the stock closed at $13.25 today.  (I made a very similar trade last month).

I have been bearish on housing for about a year now.  Evidence of this can be seen here, when I first shorted ITB (betting against US Homebuilders) back on Feb 6, 2009.  I remain bearish on homebuilder stocks because I am skeptical of an economic recovery, question the supply/demand of the market, and believe valuations are expensive.  Let’s take these one at a time.

I hesisitate to believe a bounce-back economy is upon us.  The all-inclusive unemployment is 17.3%.  Even worse, manufacturing jobs are slipping while service jobs, like government positions are holding steady.  Further, with the decline in credit, I can’t imagine many companies are expanding their capacity to produce (via more factories/machines).  With fewer manufacturing jobs and without investments in production capabilities, how can an economy produce more to enable a recovery?  I have read that even if the data somehow shows a recovery, it will be not only a jobless recovery, but a job-loss recovery.

To get a sense on how unemployment affects the housing outlook, consider this from Mark Zandi, chief economist at Moody’s Economy.com:

A soft job market, especially one this soft, means potential buyers don’t have money to pour into new homes or the confidence that they’ll be able to hang on to their jobs and pay the mortgage on their existing home.

Combine the weak consumer with massive mortgage rate resets (most of which are unlikely to have been modified), and it’s easy to see that supply is likely to outstrip demand.  Reasonably thinking, if consumers are unable and unwilling to purchase houses, homebuilders will have difficulty profiting from not selling houses.

To further strengthen my argument, Pending Home Sales increased in response to the government’s tax credit for first time homebuyers through October.  Then, when the tax credit was originally set to expire in November, Pending Home Sales dropped.  Now that the tax credit has been extended to April, prices have again mitigated.  This means that the deciding factor in home sales has been the tax credit.  All this is doing is pulling forward demand.  May I kindly remind the audience what happened to car sales following the end of the cash-for-clunkers program:  demand dropped to below where it had been before the program started.  I believe that since the tax credit has existed for a longer duration, the drop in home sales will be more severe.

On to valuation… Yahoo shows the P/E of ITB at 23.7; given my thoughts above, I think this is absurdly high.  Perhaps earnings are depressed, which could warrant a high multiple.  However,  I argue that earnings will continue to be depressed, at least through the first half of 2010.

As far as execution goes, I would have liked to have shorted an additional 100 shares of ITB, but there were none left to borrow at my brokerage.  So, I purchased 3 put contracts at the July $17.50 strike, for $4.70 each.  Considering ITB is trading at about $13 per share, I am quite content with a $12.80 break-even price.  I’m hardly paying a premium–only paying $0.20 for six months of time decay.  (For the options gurus, the volatility was 30, which is what I consider an inexpensive option contract).

A final note…  One of the neat things about trading options that are deep-in-the-money is that sometimes you can see your volume.  If you look up the .ITBSW option, you can see three contracts traded today; those would be mine.  I have displayed this below in the red circle.  To the left of it, you can also see the $4.70 that I paid for each of them.