Homebuilders Roar Back to Life

 | Jan 04, 2012 | 12:30 PM EST
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This commentary originally appeared Jan. 04 on Real Money Pro – Click here to learn about this dynamic market information service for active traders.

Homebuilders roared back to life in the fourth quarter, leading the upside in reaction to surprisingly resilient sales growth. But the group covered little new ground during the rally, simply regaining price levels that were lost in the summer decline. While the V-shaped action didn't trigger a big breakout, it generated technical improvement in the long-term patterns, which now point to even higher prices.

This is dovetailing nicely with an upturn in the banking sector, suggesting the fragile U.S. recovery will pick up steam heading into the November presidential elections, despite the European crisis. These emerging uptrends give long-minded traders and investors a choice between two sectors that have grossly underperformed the broader market in the last three years.

You might be thinking, "Why bother with housing stocks when I can go out and buy a few banks instead?"

You may be right, but the financial sector requires a more complicated bet that includes assumptions about local regulation and international exposure, while the housing sector is a purely American play for 2012. Thus, I believe it will be the stronger performer.

No, I don't expect foreclosures to magically disappear and new waves of buyers to ignite another real estate bubble. To be honest, that isn't required for a new sector bull market, because the 2008 collapse has been fully discounted by market players after three tortuous years, so even gradual improvement should attract a steady flow of buying interest.

Source: eSignal

The PHLX Housing Sector Index (HGX) dropped to 54 from 294 between 2005 and 2009, and then retraced less than 38% of the decline into the April 2010 high. It then rolled over in a two-legged downtrend, finally bouncing in October about 20 points above the two-year low. The index is now lifting toward resistance at a lower-highs trendline (red line) and the 200-week exponential moving average.

Even though the index turned higher well above the 2009 low, I believe the decline constituted a major test because many components, including Toll Brothers (TOL) and Ryland Group (RYL), actually undercut their lows in October, before reversing with the sector and broad market. If I'm right, the index will now lift into long-term resistance and break out in a new uptrend.

There are two ways to play a group recovery. First, buy the sector's strongest components, assuming they'll continue to lead in the next rally wave. Second, buy the laggards and hope they play catch up with their stronger peers.  The first strategy will work better if first-quarter data shows regional strength and weakness, while the second will work better if a healthy economy "floats all boats."

Let's look at a profitable play for each of these complimentary strategies.

Source: eSignal

Lennar Corp. (LEN) is a sector leader that's posted a series of higher lows off the bear market low at $3.42. It topped out near $21 in 2010 and dropped into a broad rectangle (blue lines) that's still in play. The stock tested pattern support in October and has now risen to within two points of resistance. More important, it's grinding out the final stage of a four-year inverse head-and-shoulders breakout pattern.

The stock will need to get above a red zone of resistance between $21.50 and $23 to complete a multiyear breakout and enter an uptrend that eventually finds its way into the $40s. There's too much risk until it pierces that level, so I don't recommend taking an early position. Instead, get this promising play onto your trading screens and watch the big resistance level.

Source: eSignal

PulteGroup (PHM) has struggled to keep its head above water in the last two years, finally breaking the 2008 lows (red lines) in August. It plunged to a 15-year low at $3.29 in October and bounced in a strong recovery that's stalled at resistance, defined by the summer breakdown. Accumulation rocketed higher in the fourth quarter, with On Balance Volume (OBV) now sitting at an 18-month high (green lines).

This underlying enthusiasm signals a strongly bullish divergence that should generate a healthy breakout above $7 and a buying spike that tests the lower-highs trendline (blue line) in place since July 2010. Aggressive players can open small positions when the stock pushes above the 2008 low and then add more exposure following a breakout above that resistance line.

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