Home-Builder Stocks on the Rise
Despite Rising Inventories

It is easy to do a double take when looking at home-builder stocks.

The supply of new and existing homes remains historically high and out of whack with demand, a situation unlikely to abate anytime soon. The economy, meanwhile, is on the skids and mortgages are harder to obtain. The S&P/Case-Shiller home-price index, released Tuesday, showed record price declines continued into the new year, with half of the 20 reporting markets posting double-digit-percentage declines in January, compared with the year-ago month.

So how come home-builder stocks are outperforming the rest of the stock market? This year, the stocks of the 11 home builders tracked by UBS have risen 31% as of Monday. By contrast, the Standard & Poor's 500-stock index declined 8.1% during that period.

Some of the rise in builder stocks reflects perceptions that the economic fundamentals in the industry have hit bottom and are poised for a turnaround. On Tuesday, JMP Securities analyst James Wilson upgraded several home builders, including D.R. Horton Inc. and Pulte Homes Inc.

The builders also are getting help from the government. Mortgage behemoths Fannie Mae and Freddie Mac, along with the Office of Federal Housing Enterprise Oversight, last week announced a reduction in required capital surplus, possibly pumping as much as $200 billion into the mortgage-backed securities market. That added liquidity in the mortgage market could help the builders' customers obtain mortgages.

But a bigger factor behind the rise in home-builder stocks is technical and reflects buying and the selling maneuvers of Wall Street traders. Builder stocks have seen rampant short selling. In a short sale, traders sell borrowed securities and hope to make a profit by buying an equal number of shares later at a lower price to replace the borrowed securities. But since builder stocks have risen instead, these investors are buying stocks daily to cover their short positions.

Both Beazer Homes USA Inc. and Standard Pacific Corp. had short interest of 70% of their outstanding shares, according to J.P. Morgan's latest short report. As the stocks showed gains, more short sellers rushed to buy the stocks and close their negative bets. Buying at the end of a short trade often drives shares higher, and the trading volumes are high relative to shares outstanding and market capitalization.

"Whenever we see a glimmer of hope in the macro environment," shorts pull out, said David Goldberg, home-building analyst at UBS.

This cycle is likely to perpetuate. The amount of short interest in home-builder stocks -- the number of shares that have been sold short and not yet repurchased -- has reached a record this month, according to a research report by Zelman & Associates. The aggregate home builders' short interest increased this month to 23% from 21.9% of shares outstanding in February. This month's level of short interest is 4% above the previous record set in December 2007, Zelman & Associates said. "It's a lot of short covering," said Mr. Goldberg. "I think these stocks are going to give back a lot of their gains. They are overdone."

-- Michael Corkery contributed to this article.

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