Lumber Prices May Burn Real Estate Bears

The effect of lumber prices on real estate is undeniable. As such, lumber prices can be used as a forward-looking indicator for the housing sector. Right now, lumber is carving out a potential inverse head-and shoulders bounce that may burn real estate bears.

What do lumber prices have to do with real estate?

A whole lot more than most investors think.

In fact, the correlation between lumber and real estate is one of the least known, but most accurate forward-looking real estate indicators.

I know this sounds a bit obscure, but you can’t argue with the charts. The long-term correlation chart between lumber and the PHLX Housing Sector Index is available here. Is the Housing and Real Estate Recovery here to Stay?

The key point to keep in mind is that lumber prices lead real estate prices by about 14 months.

With that in mind, let’s look at the lumber chart.

  • Lumber formed a potential head-and shoulders bottom with the (green) neckline around 340.
  • Lumber pushed above the HS neckline and the red trend line resistance.
  • Measured HS target is around 395
  • As long as trade remains above 340, the HS target remains active

Such a rally (assuming it materializes) should be felt in the housing market about 14 months later.

Of course a relapse below 340 would hint at a failed HS breakout and further weakness, which should translate into softer home prices … 14 months later.

Some of you may still wonder if lumber prices are really a ‘legit’ indicator.

Almost exactly a year ago (August 27), we published a lumber chart with a 14-month outlook via this article: How to Turn the Lagging S&P/Case-Shiller Home Index into a Leading Indicator

With the benefit of hindsight, we can now check if lumbers message a year ago proved correct.

Below is the original August 27 chart. The green graph represents lumber prices set forward by 14 months. The blue graph reflects the actual performance of the PHLX Housing Sector.

Major ‘pops and drops’ in lumber prices (such as in 2013) tend to show up muted in the real estate market – which is what happened again over the past 14 months – but directionally real estate continues to follow the beat of lumber.

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

How to Turn The S&P/Case-Shiller Home Price Index into a Forward-Looking Indicator

The S&P/Case-Shiller Home Price Index of 20 big metropolitan areas rose a seasonally adjusted 1.1% from February to March and 10.9% year-over-year. This is the largest monthly gain since April 2006. This is great news, but ‘old’ news. What happened in March doesn’t tell us about the future. Here’s what can.

The largest gain for home prices in seven years is reason for cheer, but will the trend continue? Is it possible to turn the lagging S&P/Case-Shiller Home Price Index into a leading indicator for the real estate market?

The S&P/Case-Shiller Home Price Index is one of the most popular and most widely accepted gauges for real estate prices, but it is not a leading (as in projecting future prices) indicator.

In fact, the S&P/Case-Shiller Home Price Index is calculated using a three-month moving average (the averaging methodology is used to offset delays that may occur in the flow of sales price data) and is published with a two-month lag.

Today’s brand new S&P/Case-Shiller Home Price Index readings covers data from January – March 2013. So data is delayed and represents a snapshot of the past with no influence on future prices. It’s a classic lagging index.

How can you turn a lagging index into a leading index?

One method we’ve used successfully in the past is to ‘enhance’ the rear-view mirror message of the S&P/Case-Shiller Home Price Index with the predictive qualities of lumber prices.

This is not an exact science, but lumber prices tend to set the rhythm for home prices. This makes sense; after all lumber is the key ingredient for every residence.

Previous analysis of this correlation in October 2012 and March 2013 suggested higher real estate prices.

The chart below plots the price of lumber against the PHLX Housing sector. Lumber prices are set forward by 14-months to express the ‘crystal ball-like’ properties of lumber.

Lumber prices soared 53% from September 2012 to March 2013. The strong real estate performance is therefore no surprise and according to lumber, more gains are ahead for housing.

But over the last two months lumber prices have dropped 32%.

Lumber’s wild 53% gain and 32% drop are not yet reflected by the housing sector index.

The correlation between lumber and the housing sector is not perfect, but it should cause some ripples for the housing market soon.

It will be interesting to see if lumber prices peaked for good or just entered a correction. A permanent peak for lumber could translate into a 2014 top for real estate and opportunities for real estate ETF investors.

Leading Indicator Projects Still Higher Real Estate Prices

According to some measure, real estate prices just recorded their biggest annual gain since 2006 and surveys show that Americans’ confidence in real estate is growing. Contrarians may consider this to be bearish, but one leading indicator doesn’t.

The S&P/Case-Shiller Home Price Index has become an important gauge of the real estate market. Index levels are updated on the last Tuesday of every month (that was yesterday).

The January data (the index uses a 3-month average and is published with a 2-month lag) showed a 0.1% month-over-month and an 8.1% year-over-year increase for the 20-city composite. The YOY figure was the biggest jump since the summer of 2006.

Compared to what we’ve gotten used to, this sounds grandiose. The first chart below puts last year’s gain into perspective. Although it looks less earth shattering, the increase is respectable.

Forward-looking investment decisions aren’t based on rearview mirror-focused analysis, so what’s next for the real estate sector?

Quirky but Credible Leading Indicator

In the October article “Is the Real Estate Recovery Here to Stay?” I introduced a quirky but credible leading indicator for real estate prices – lumber prices.

Lumber is a key component for every house, therefore seeing the connection between the raw material (lumber) and finished product (house) isn’t much of a stretch.

The October article plotted lumber prices set forward by one year against the PHLX Housing Sector Index and highlighted the correlation between major tops and bottoms (something we won’t do today).

 

Our conclusion, based on the leading lumber prices indicator, was that the housing recovery would last at least into mid-2013.

Why 2013? Because lumber broke through trend line support. At the time we didn’t know if this would end the lumber rally or not.

Today we know that lumber prices recovered and soared on to new recovery highs.

The October article noted that the correlation between lumber and real estate prices might be even better if lumber prices are set forward by more than 12 months. The chart below does just that. It plots the PHLX Housing Sector Index against lumber prices set forward by 14 months.

Obviously, the strong rally in lumber prices bodes well for real estate prices and real estate ETFs like the iShares Dow Jones US Real Estate ETF (IYR) or Vanguard REIT ETF (VNQ).

This indicator allows us to peek ahead a year or so and no further. The lumber rally has slowed as of late and various resistance levels (dashed red lines) are not far away.

It is possible that the real estate rally will run out of steam in mid-2014. If that’s the case, lumber prices will be our canary in the mine.

Is the Housing and Real Estate Recovery Here to Stay?

The S&P Case/Shiller Composite 20 Home Price Index just saw its sixth consecutive monthly increase (see chart below).

The index is a composite index of the home price index for 20 major metropolitan areas in the US. Many analysts look at the 6-month recovery (short red “tail”) and are ready to pronounce a permanent bottom for the housing and real estate market.

Obviously, this would be bullish for the iShares Dow Jones US Real Estate ETF (IYR), SPDR S&P Homebuilders ETF (XHB), and the overall real estate sector. But does this recovery have legs?

An Odd but Effective Indicator

It’s said that the end justifies the means and that may be the case with the quirky forecasting tool I’m about to introduce. This indicator has to do with lumber prices.

Lumber is a key component for every house and seems to play a role as a leading indicator. It seems that lumber prices tend to rise about a year before the housing sector.

The chart below plots lumber futures against the PHLX Housing Sector (HGX – not an ETF). HGX includes companies like Pulte Group, Standard Pacific, KB Home, DR Horton, Fidelity National Financial, Weyerhaeuser, etc.). I have set the lumber price forward 1 year to capture lumber’s leading indicator role.

The red arrows show the correlation between major highs and lows. Based on the tilt of the red arrows it might be even more appropriate to increase the lead from 12 to 15 months. Regardless, up until mid-2009 the correlation worked like a charm.

Enjoy it While you Can

Since mid-2009 the gyrations of lumber prices have been more pronounced and less correlated compared to the housing sector. I’m not sure why (massive monetary manipulation by the Fed likely plays a role). Assuming that the directional analogy will continue (or resume), lumber prices suggest that the housing recovery will last into mid-2013.

As of late, lumber prices have fallen through trend line support (black line), which is a bearish development. It will take time to determine just how bearish, but lumber futures suggest more weakness in mid-2013.

A resumption of the housing slump about a year from now would certainly harmonize well with our overall forecast for the stock market.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.