Readers have made 37% since the beginning of this month…

In the November issue of my newsletter Sjuggerud Confidential, I recommended just one stock – a homebuilder. As I write, the stock is up a remarkable 37% since November 1.

Two weeks before, in my letter True Wealth, I recommended shares of another homebuilder. That stock jumped 9.5% in one day last week – the day it released horrible earnings. Why did it rise? The news was less bad than analysts were expecting.

I’m not recommending shares of homebuilders because I expect a housing recovery. This is not a story about rising home prices. It’s a story about hated stocks.

I recommended homebuilders to my subscribers because of what I call “The Secret to 1,000% Gains.” The secret is this:

The big money is made when things go from bad to less bad.

A month ago, things got less bad for homebuilders, as I’ll explain. Importantly, the last two times this happened, shares of homebuilders rose fivefold in 30 months or less. (That’s not quite 1,000%, but it’s still extraordinary!)

Specifically, the survey of homebuilders by the National Association of Home Builders got less bad a month ago. The survey ranks homebuilder sentiment on a scale of 1 to 100. It peaked above 70 last summer. And then it slowly meandered downward for a year. But its slide gained steam in the last few months, crashing down to 30 in September. That was the lowest reading since 1991.

That “30” told me things looked really bad. When October’s number came out at 31, it became official... Things went from bad to less bad. So in my True Wealth newsletter, we bought homebuilders.

Looking back at the past bottoms in this survey, in October 1990, the Datastream Homebuilders Index, which tracks homebuilder stocks, bottomed below 400. By the end of 1992, it was near 2,000 – a fivefold increase in just over two years. The amazing thing is that the earnings of these homebuilders were cut in half over the same period. That’s right… while earnings were falling dramatically, homebuilder stock prices were rising even more sharply. What the heck happened?

Here’s what happened… In 1990, people realized that earnings of homebuilders were going to tumble. So everyone dumped the stocks. By October of that year, homebuilding stocks had lost half their value.

Homebuilder sentiment stood at 60 going into 1989. But conditions deteriorated. By August 1990, it had fallen to 30. Homebuilding stocks bottomed a month later. Homebuilder sentiment continued to fall, dropping to a record low of 20 at the beginning of 1991. The stock prices of homebuilders started to rise.

That meant the stock market was correctly “predicting” that the worst was nearly over for homebuilders. The shares had lost half their value and were trading at a P/E of 5 in October 1990 simply because everyone expected next year’s earnings to be down. So even when 1991 earnings were half of 1990’s, the stocks went up at that time – fivefold in just over two years!

BUY HOUSING STOCKS WHEN HOMEBUILDERS ARE SAD

Fifteen years ago is not the only time we’ve seen this cycle. In 1981-82, the same thing happened… Shares of homebuilders got super-cheap because everyone knew earnings would be bad. Earnings fell by half… and at the same time, the shares started to soar… rising fivefold in under three years.

The setup looks similar today. Shares of big-time homebuilders, such as Toll Brothers, fell more than 50% from July 2005 to July 2006. As a group, the big homebuilders now trade at a P/E of between 5 and 6 (which is comically cheap) because everyone knows that their earnings are going to be terrible in the next year.

Homebuilding stocks have been rising for three months now at a time when article after article reports terrible news about the sector. Look, these stocks are rising on bad news. Just imagine what a bit of good news could do for them. You want to own stocks that rise on bad news, and that’s homebuilders now.

To sum up, the shares of U.S. homebuilders have lost 50% of their value and now trade incredibly cheaply at a P/E of between 5 and 6. They’re cheap because everyone knows their earnings will be bad. That’s okay – that’s what happened 15 years ago… The stocks got cheap, earnings then fell in half… and the stocks rose fivefold! So asking for a 200% gain in two years isn’t asking much. The news is terrible, but shares of homebuilders are rising. Things have moved from bad to less bad. Time to buy!

Good investing,

Steve

Editor's note: Steve Sjuggerud is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.