Avoid Home Builders, REITs and Banks Now

IN THE EARLY 1960S, mathematician Edward Lorenz popularized the concept of the "butterfly effect," in which small variations of one aspect of a system can dramatically affect the systems' long-term results. It refers to the idea that a butterfly's wings can create a tiny change in the atmosphere that can ultimately cause a tornado. The butterfly's wings change wind conditions on a small scale that eventually creates the much larger storm.

That's quite familiar to those of us who trade. Of course markets don't operate in a vacuum: They are in a constant state of flux, revaluation and change. A parts supply problem for a game made by Sony (SNE), for example, will affect its earnings, along with those of companies like FedEx (FDX) who ship it, retailers like Best Buy (BBY) who sell it and the stocks of asset managers like T. Rowe Price Group (TROW) and Franklin Resources (BEN) that might hold them all. One butterfly, in this case, a Japanese butterfly, sets off the entire chain.

Given the correlation of major markets these days, one has to be aware of the saga now unfolding in the subprime mortgage and banking sectors, where troubles at two large Bear Stearns (BSC) hedge funds appear to be catalysts for critical weakness in three sectors that most of us had become accustomed to as leaders.

Take the home builders, which spent the first half of this decade on an upward tear that would have put any technology growth stock to shame. From 2002 to 2005, names like Beazer Homes (BZH) and Hovnanian Enterprises (HOV) ran upwards of 250% or more, quickly finding their way into the portfolios of individuals and institutions alike.

Six-month comparison of BZH, TOL, HOV, CTX, PHM

Nowadays, however, the sector is unrelentingly weak, with names like Pulte Homes (PHM), Centex (CTX), Toll Brothers (TOL) and KB Home (KBH) notching new multimonth lows almost daily. Weak stocks tend to stay weak, or at least comparatively weaker than others, and from my perspective, none of these has exhibited the sort of exhaustion selloff that would signal a tradable bottom is finally in place.

From home builders to homes brings our attention to real estate, namely REITs. We've participated in and written about REITs for the better part of six years, going back to our 2001 article "The Hard Facts," back when REITs were still yielding in excess of 7%. For comparison's sake, benchmark ETF iShares Dow Jones US Real Estate (IYR), which hadn't even been launched back then, now yields less than 3.5%. Over the past few years, REITs were owned successfully by income and growth investors alike, and have now become an accepted and commonplace part of a diversified portfolio.

But when evaluating recent price action, it would appear the only action in REITs these days seems to be from the private-equity players, who have opportunistically taken a number of REITs private in recent months, most notably Blackstone's historic $23 billion purchase of Equity Office Properties in February. In terms of general price action, the sector as a whole seems to be breaking down hard, with names like Kimco Realty (KIM), Developers Diversified Realty (DDR), Boston Properties (BXP) and CBL & Associates Properties (CBL) all exceptionally weak.

I can distinctly remember during the 2001-2002 bear market, REITs were the strongest group even as companies like Cisco Systems (CSCO) and Sun Microsystems (SUNW) were imploding. Now when the market falls, it's almost as if the REITs are leading the charge lower. Along with home builders, this is another sector I'd look to avoid in the current environment.

Six-month comparison of IYR, CBL, DDR, BXP, KIM

Probably the most disturbing element of the chain reaction that appears to be unfolding is the quiet damage being inflicted on a number of banks and savings and loans, which have been consistent leaders ever since the technology bubble burst in 2000. Banks big and small have been such persistently strong stocks that it's almost hard to imagine them as anything but. In fact, we highlighted the group just last year as exhibiting strong leadership.

That was then, this is now. Times have changed. Taking a look at some of those charts, however, might change your mind as it has changed mine. Names like Hudson City Bancorp (HCBK), Astoria Financial (AF), Provident Financial Services (PFS), Brookline Bancorp (BRKL) and People's United Financial (PBCT) have all weakened dramatically in recent days, a move undoubtedly exacerbated by worries over a declining mortgage and real estate market. Thus far, the major damage appears in the regional savings and loans, but I've become more concerned that, if the trend persists, weakness could spill over into widely held names such as JPMorgan Chase (JPM) and Citigroup (C).

Market moves don't generally develop overnight, but unfold over weeks and months. By the time the "story" hits the front page, the price action has already occurred. And while I'm not sure of the exact butterfly that set this series of events into action, it's becoming increasingly clear that securities connected to the mortgage, home-building and savings-and-loans sectors are among the weakest names on the board. For my money, traders would be best served avoiding them. Looks like a tornado is on its way.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.