Lumber Is The Canary In The Homebuilders’ Coal Mine
Summary Lumber prices have historically tracked quite well with homebuilder stocks. Homebuilders have also recently surged past the S&P in recent months. With the deceleration in price gains still going on and Fed support quickly evaporating, there is nothing left to prop up this industry. While I have been generally skeptical of the supposed recovery in homebuilder stocks, I have limited my analysis to trends in home prices and the ability of the American consumer to handle a mortgage at current prices. For me, this analysis is sufficient to show that homebuilder stocks are in a pretty large bubble. In the following article, though, I plan to show the value of homebuilder stocks relative to lumber prices, which themselves are a good economic indicator, but also tend to follow the valuation of homebuilder stock. The Tight Relationship of Lumber and Homebuilders (click to enlarge) In the preceding chart, I have plotted the SPDR S&P Homebuilders ETF (NYSEARCA: XHB ) and spot lumber prices. A clear correlation emerges from before 2009 to around 2013. What we also see is that around 2013, while lumber prices crashed, homebuilder stocks continued onward, and more recently have even seen some gains. Generally lumber prices are thought to track the economy quite well. While many economic analysts have been bullish on the future of the US economy, commodity and bond markets have been showing for more than a year now signs of languish. A plot of corporate bond prices would show much the same thing as lumber prices in this graph, as they also have stalled starting around the beginning of 2014. More interestingly, other commodities have started to follow along in this weakening trend, with oil recently showing a spectacular fall and copper following along. Commodity markets are showing signs of warning about the future of the economy. Lumber especially has shown a historical tight relationship with the value of homebuilder stocks, and given what has happened over the past two years, we ought to be worried about the future prospects for share prices. The next plot that I have shown is the past 6 months of the relationship between lumber and XHB. (click to enlarge) What we see from this chart of the relative valuation of XHB to lumber prices is that they have traded in a relatively tight range. Starting in 2015, however, we notice a sharp spike upwards that was quickly corrected. Over the past few days this relative valuation has shot up again. Given the last swift correction in this ratio, we can probably expect homebuilders to go down in the near-term. The homebuilder rally seems to be losing steam, as the market reacted violently to this push above historical highs. Future Prospects for Timber (click to enlarge) In order to predict future movements in the price of wood, shown above is a graph of the iShares S&P Global Timber & Forestry Index Fund (NASDAQ: WOOD ). Chaikin Money Flow analysis shows strong price growth ending around the middle of September, interrupted by a strong selloff in October, corresponding quite nicely with the overall stock market. Interesting is that since then there was a brief rise in money flow, but even while this has slowed noticeably, the price appreciation has still continued. This seems like price gain without much support, and so even timber prices themselves may be unsustainable in the medium term. What is more worrying for timber prices is the state of the overall economy. Consistently low oil will likely result in slowed economic activity as oil exploration companies drastically reduce capex spending. With decreased capital spending, we can assume downward pressure on GDP growth, which is an ominous sign for timber, as well as for housing. Technical Analysis of XHB (click to enlarge) Technical analysis of XHB itself shows signs of weakness. At the end of November XHB reached a value of about 33.50, at which point momentum was lost and the stock began to fall. While XHB has been higher since then, it also has not been able to make any real progress. Volatility in XHB has drastically increased since that time, and perhaps a greater source of worry is the Chaikin Money Flow, which turned definitely negative throughout December and has not been solidly positive since then. The market seems to find the current valuation as high enough. Summary and Action to Take XHB has seen to lost momentum, as it has not been able to have a solid increase in value since the end of November. In addition, the trend of homebuilders with XHB is approaching historic highs, and this has been met with swift correction in XHB. The long term trend shows definite signs of worry, as lumber has not agreed with the high current valuation of XHB. Now would be a great time to sell any shares of XHB, as the stock is not likely to go any higher from here on. For a more speculative investment, shorting XHB would likely be a good idea. A long time horizon is probably needed for that trade to play out, though, as XHB has been able to keep this high relative valuation for more than a year now, and only time will tell how long it will be able to keep this up. In addition, if you want to play on the underlying weakness of the US economy, shorting the WOOD ETF may be the way to go. If GDP is unable to sustain itself, then timber prices will go down along with it. This is a very speculative move, however, since timber itself does not show signs of being overbought like the homebuilders. Still, timber is going to hurt if the economy slows. I still take shorting homebuilders as the safer option since not only will they fall if the economy stumbles, but they are also presently overvalued and due for a correction even if GDP does not change much. Disclosure: The author is short XHB. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.