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.

 

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.

Diversification: The Correlation Risk Trap is Real

A rising tide lifts all boats and liquidity buoys all asset classes. That’s great, but it’s not diversification. In fact, it presents a whole new type of hidden risk. Many ‘diversified’ portfolios today would fail miserably at any sort of Black Swan event.

The purpose of diversification is to reduce risk. The rationale behind diversification used to be that booming cycles of some asset classes offset the bust cycle of other assets.

Diversification made sense in an environment where some asset classes boomed while others got busted, but that isn’t the case anymore.

Today most asset classes ebb and flow at the same time, but at different degrees. This makes diversification less effective and possibly dangerous.

The first chart shows the percentage change of the following asset classes/ETFs since January 2007: S&P 500 SPDR (SPY), iShares Core Total US Bond ETF (AGG), iShares Dow Jones US Real Estate ETF (IYR), and iShares S&P GSCI Commodity ETF (GSG).

In early 2007 stocks and commodities cushioned the decline in real estate prices. In 2008 commodities lessened the sting of falling stock and real estate prices.

Then came quantitative easing and it’s become clear ever since that all asset classes swim in the same liquidity pool. Some swim faster, some slower, but all float with the tide.

Different Approach to Diversification

A less popular, more contrarian and quite possibly more effective approach to diversification involves simple under appreciated cash.

Based on Rydex funds flow data, investors are despising cash like never before. Low interest rates are partially to blame for the great cash exodus, but excessive enthusiasm for stocks is probably the main motivation.

The second chart illustrates basic support (green) and resistance (red) ranges for the S&P 500. The S&P tends to get overbought in the red and oversold in the green zone.

Over the past years, investors did well to diversify out of stocks (and other assets) into cash when prices reached the red resistance range and rotate out of cash into stocks (and other assets) in the green range.

The S&P is about to reach overbought territory and risk is rising. Raising cash may offer more risk protection than diversification.

The Profit Radar Report will provide specific trigger levels indicative of a trend change from up to down.

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.