Quirky but Accurate Indicator: Housing Sector Troubles Likely to Continue

Sometimes the oddest correlations make the best forward-looking indicators. This is certainly the case with lumber and the housing market. Here’s what this odd but accurate indicator ‘sees’ ahead for U.S. real estate.

Several times in the past we’ve looked at the correlation between lumber and housing – related ETF: iShares US Real Estate ETF (NYSEArca: IYR).

It’s an off the wall kind of an indicator, but it’s proven more accurate than any other housing indicator.

To get the correlation right, we need to set lumber futures forward by about 14 months.

The chart below does just that, as it plots lumber against the PHLX Housing Sector Index.

Lumber 514

As the gray oval on the right shows, lumber saw a big pop and drop in 2012/2013.

The two gray ovals to the left illustrate that the magnitude of such sizeable pops and drops tends to appear muted in the housing sector, nevertheless it suggested an eventual slowing of the housing market.

Lumber is currently at an interesting juncture, as lumber prices were unable to break above resistance and just fell to test support.

As of right now, lumber suggests that the housing market is not ‘out of the woods’. The housing blues may start all over if support for lumber fails.

This would not only affect multi-billion dollar ETFs like the Vanguard REIT ETF (NYSEArca: VNQ), or SPDR Dow Jones REIT ETF (NYSEArca: RWR), but also millions of Americans.

A proprietary analysis of supply and demand for the SDPR S&P Homebuilders ETF (NYSEArca: XHB) also shows that demand for homebuilding stocks is deteriorating.

 

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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.