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.

 

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.