Dissecting the Sectors: Retail and Homebuilding

Schaeffer's Investment Research
  OCT 08, 2012 1:30 PM

Contrarian investors should continue to look for trade setups where outperforming retail stocks remain unnoticed by the crowd. Investors who are long housing should consider hedging to guard against possible short-term shocks.


Here are a couple of sectors of note.

Sector: Leisure/Retail

Outlook: Same-store sales for September rose 1.3% from the previous year, according to Briefing.com, and were helped by seasonal weather and the debut of fall merchandise. For the fifth month in a row, discretionary sales trumped staples, 2.6% versus 0.9%. This is an encouraging sign that consumers remain willing to spend. On the charts, the SPDR S&P Retail ETF (NYSEARCA:XRT) successfully tested support last week at its 40-day moving average, which is parked in the $62 area, site of the security's March/May highs.

The next technical hurdle for the XRT -- beyond its annual high at $65.57 -- could come around $67.50. This is roughly 50% above the key $45 mark, which acted as a ceiling in June 2007 and April 2010, before providing support in August/October 2011. On the options front, we are seeing huge put open interest in the front-month series for XRT, which suggests long players in the sector are hedged via the ETF, and could mean limited downside on pullbacks.

As far as specific equities go, we prefer stocks that have enjoyed positive reactions to earnings and/or same-store sales numbers, such as Lululemon Athletica (NASDAQ:LULU). Contrarian investors should continue to look for trade setups where outperforming retail stocks remain unnoticed by the crowd. Given recent indications of overexposure on the part of hedge funds, however, we would recommend avoiding any "popular" stocks in this group that have suffered poor price action. One example of this phenomenon is Sears (NASDAQ:SHLD), which is among the top-50 holdings at these prominent hedge funds, despite dropping roughly 34% from its March peak. Sector: Homebuildng

Outlook: We continue to see evidence that the housing sector is in recovery mode. Recent reports have shown housing starts at a 28-month peak, existing-home sales at a 27-month best, and home prices at a new five-year high. Plus, the Fed's plan to buy mortgage-backed securities as part of its QE3 endeavor is even more bullish for homebuilders. This past week, the average 30-year mortgage rate dropped to 3.36%; such a low reading could be a fundamental tailwind for the group, as real-estate investments become a more attractive prospect. Despite all of this positive news, housing skeptics continue to compare current data to pre-bubble levels.

Many of the key stocks in the group remain heavily shorted, and Reuters recently reported that a popular hedge fund manager is betting against the sector. This downbeat backdrop is encouraging for contrarian investors, as it sets the stage for positive momentum on any good news. For example, KB Home (NYSE:KBH) spiked to a new 18-month high after its late-September earnings report, which topped lowball consensus estimates. The SPDR S&P Homebuilders ETF (NYSEARCA:XHB) is currently trading above the $25.65 level -- marking a more than 50% year-to-date gain -- which is an encouraging sign, as this could have been a speed bump for the security. Meanwhile, XHB's 50-day put/call volume ratio on the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) stands at 1.71, as puts bought to open have nearly doubled calls during this time frame. We saw a similar pop in this ratio in February, preceding a three-month rally in the ETF. This latest uptick could be the result of hedge funds using these puts to protect the long stock positions they've been accumulating. Hedging is a bargain on this ETF of late -- especially for short-term options -- as implied volatility is just off annual lows.

As a result, individual investors who are long housing may also want to consider hedging with the broader puts to guard against possible short-term shocks. In addition to KBH, some of our preferred names in the group include PulteGroup (NYSE:PHM), D.R. Horton (NYSE:DHI), Toll Brothers (NYSE:TOL), Lennar (NYSE:LEN), and Meritage Homes (NYSE:MTH), due to a combination of solid price action and lingering skepticism from Wall Street. Going forward, all of these technically strong names could enjoy additional upside spurred by short-covering support and/or analyst upgrades.

(See also: Ride Out the Short Term for the Next Major Market Surge, What to Expect in the Fourth Quarter of an Election Year, and This Week's Key Events: Earnings Season Begins and PPI Data Hits the Street.)

This article by Schaeffer's Editorial Staff was originally published on Schaeffer's Investment Research.

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