Analysts at JP Morgan are looking ahead to a recovery, even as bad news abounds. By Anne Kates Smith, Senior Editor October 10, 2006 Today's column is a lesson in the intestinal fortitude it takes to be a stock market investor. Consider: As evidence continues to mount that the long-feared housing slowdown is real, brutal (at least in some places) and potentially long-lasting, one savvy analyst sparked a rally in homebuilders with a bullish recommendation to buy a handful of stocks in the beleaguered group. On October 10, JP Morgan analyst Michael Rehaut and colleagues published a positive report on homebuilding overall, upgraded the firm's neutral stance on D.R. Horton (DHI) and Standard Pacific (SPF) to "overweight" -- that means go ahead and buy -- and raised the rating on Toll Brothers (TOL) from "sell" to "neutral." What, are they crazy? The market didn't think so. Standard Pacific and Toll Brothers logged 5% gains following the upgrade, to $26.62 and $30.29, respectively; Horton was up 4%, to $24.76. Other homebuilders followed suit, including KB Home (KBH), up 2%, to $45.75. The day's gains added to a nascent recovery that's been quietly in place since last summer. Before yesterday's rally, homebuilding stocks as a group were up 18% since July -- but still 43% below their August '05 peak. At the moment, the news couldn't be worse for homebuilders. Moody's Economy.com released a 192-page report earlier this month forecasting that 100 metro markets -- accounting for nearly half the value of the nation's single-family housing stock -- will probably see price declines by this time next year. Twenty metro markets are likely to crash, says Moody's, notching double digit declines from peak prices. Declines could last into 2009. As third-quarter earnings season opens, homebuilders certainly aren't sounding optimistic. Even as their stocks rallied October 10, homebuilders issued dire warnings. Horton said orders fell 25% for the quarter (its fiscal fourth quarter) and cancellations rose to 40% from 29% a year ago. M/I Homes (MHO, $36.61) reported a 51% drop in orders for the third-quarter. "At this point there appears to be no evidence that conditions will improve in the near-term," said M/I Homes chief executive Robert Schottenstein. In September, Miami-based Lennar Corp. (LEN, $46.92) reported just a 5% dip in orders, but still warned that the homebuilding downturn has yet to find a floor. So why buy homebuilders now? That's where the fortitude comes in. The folks at JP Morgan make the case that the bad news is old news -- even as the negative announcements continue to come, they've already been anticipated by investors and are reflected in share prices. Now it's time to look toward the recovery, remembering that stock prices generally turn up before a company's business does. There is a bullish case, which begins with housing inventories. Rather than prices or orders, inventories are the key indicator for housing stocks, and they are beginning to stabilize, say the Morgan analysts. Since May, the number of new homes for sale has been essentially flat, and the inventory of existing homes has slowed nationally and across key regions, even declining from their peaks in areas -- such as Washington, D.C., and San Diego -- that were among the first to weaken. As inventories stabilize, cancellation rates should begin to improve. And the trend in new-home orders should turn positive by this time next year, if not sooner, says JP Morgan. If history is any guide, the stocks will rocket when orders start to take off. When orders picked up in 1995, homebuilding stocks rallied 51%; they rose 189% after orders turned up in 1991. A couple of other historical factors argue in favor of housing stocks. Following the Fed's last two pauses, the group gained 93% and 49% over the next 12 months. And the period from November to February is traditionally the group's strongest period, with homebuilders logging average gains of 21% since 1991, compared with just 5% for the SP 500 index. Among large-cap homebuilders, JP Morgan favors Horton and Pulte Homes (PHM, $34.07). Horton's aggressive approach to cutting inventory could pinch margins now but allow the company to recover faster than its peers next year. Pulte gets a "buy" rating because of its above-average geographic and demographic diversification. Among midsize companies, Morgan favors Standard Pacific, as well as MDC Holdings (MDC, $51.05). Shares of SPF are a bargain relative to those of its peers, more than making up for the company's exposure to iffy markets, says Morgan. MDC also trades at an attractive price, and its deft management of land, owned and optioned, should allow profit margins to stabilize quickly. Don't confuse fortitude with foolhardiness when it comes to these stocks. Better to build a position gradually over the coming quarters than to load up all at once. And if it works out, maybe it'll make up for the markdowns you're taking on your house.