EMH (Part 3): The Home Builders

Tuesday, March 13, 2007 | 06:16 AM

We've looked at the Efficient Market Hypothesis (EMH) repeatedly over the years. Our conclusion has been that eventually, markets are mostly kinda efficient. Sometimes it takes years for markets to integrate all the good or bad information relevant to a given stock or market -- as was the case with Apple's iPod or with Enron's blowup.

Over the short to intermediate terms, markets can be astonishingly inefficient. This is one of our reservations about Prediction markets -- they tend to be shorter term in duration. They are more likely to run into the sorts of inefficiencies we see characterized even with widely followed companies, like Apple and Enron.

What's been even worse, we continue to see people reaching all manners of ill-advised conclusions from the shorter duration charts of various flavors and sectors; these have the unfortunate tendency to lead the faithful astray. In the past, we have advised to "Beware Economists seeking guidance from stock markets;" the very same meme applies to traders and strategists drawing bold conclusions from very short term charts also.

Which leads us to some recent charts. Let's take a look at the Home Builders:  Its amazing that some people claim to read charts, yet manage to draw the precisely wrong conclusions from them. Remember, since no one knows the future, all investing and trading are games of probabilities regarding any given possible outcome. We cannot expect perfection -- but we can at least hope to see some measure of intellectually defendable theories.  All too often, even that modest goal is missed. 

A classic example of this misunderstanding has been the action in the Homebuilders over the past few years. For our purposes, let’s look at the bigger builders: Lennar (LEN), Toll Brothers (TOL), KB Homes (KBH), Pulte Homes (PHM), Centex (CTX), Beezer (BZH).

Our story so far: Many of the Home Builders ramped up from 2003-2005. This took place due to ultra cheap mortgage rates, utterly rampant real estate speculation, and extremely lax lending rules. Indeed, the Home Builders as a group hit their highs at the peak of the R/E market in Summer 2005. (BZH was the exception, peaking in January 2006). Given that the market is supposedly a discounting mechanism -- and the stocks were cheap on a P/E basis -- some people took this to mean that Real Estate was just fine, and there was no Housing slow down coming. Of course, we now know that was utterly wrong. The stocks in this sector got cut in half over the next year:

Firm High Low Recent High
Lennar (LEN) 68.66 (7/29/05) 38.66 (7/14/06) 56.54 (2/2/07)
Toll Brothers (TOL) 58.67 (7/22/05) 22.22 (7/21/06) 35.64 (2/2/07)
KB Homes (KBH) 85.45 (7/22/05) 37.89 (7/21/06) 56.08 (2/2/07)
Pulte Homes (PHM) 48.22 (7/29/05) 26.02 (7/21/06) 35.56 (2/2/07)
Centex (CTX) 79.66 (7/22/05) 42.90 (7/21/06) 56.66 (12/29/06)
Beezer (BZH) 82.14 (1/13/06) 35.96 (9/08/06) 47.60 (12/29/06)

Then came the lows over the Summer 2006. As Housing stocks rallied off of these deeply depressed levels, we (once again) heard the same types of faulty reasoning. The misinterpretation for the charts: proof that the Housing bottom was in, and that Real Estate would not be a further drag on the economy. Wrong, and wrong again.

Lastly, came the rally off of these lows. Again, cads and fools mustered this as proof that Housing was okay. As the charts below now show, that bounce is over and all of these stocks have rolled over; many have revisited their prior "bottoms," and a few even made fresh lows.

There are lessons here for those astute enough to note the difference between academic theory and stock reality. First, markets can be astonishingly inefficient, especially over the short term.  Second, drawing broad macro conclusions from these "wiggles" is a fool's errand. Last, tops and bottoms are notoriously bad places from which to extrapolate out towards infinity.

click for larger charts







Note: The ISE HomeBuilders Index doesn't go back far enough to be instructive, as it began trading around June 2005 (another lesson as it came out near the peak, as often occurs with Wall Street products) We include it for the sake of completeness:


All Charts via StockCharts.com

Tuesday, March 13, 2007 | 06:16 AM | Permalink | Comments (20) | TrackBack (1)
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Tracked on Mar 13, 2007 2:24:37 PM


I didn't use the sub-prime lenders as an example, as it was too easy.

Posted by: Barry Ritholtz | Mar 13, 2007 6:56:34 AM

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