A Very Large Tree Is Falling In The Stock Market Forest

by: Eric Parnell, CFA

"If a tree falls in a forest and no one is around to hear it, does it make a sound?"

Media outlets have been gushing nearly every day about the extraordinary recovery in the housing market. After many very difficult years following the bursting of the housing bubble and the outbreak of the financial crisis, this is certainly welcome news. The strength of the housing market is not only a key driver of economic growth, but it is also an important source of optimism for risk asset prices including stocks. But despite all of the apparent good news, some troubling signs remain that are undermining this story. And unless one particular trend changes soon, it may have negative implications for the stock market going forward.

The housing market has clearly improved from the depths of a few years ago, and a variety of data support this conclusion. For example, the monthly supply of homes on the market has fallen from the crisis highs of more than twelve months to historical lows at just over four months today, according to the U.S. Department of Commerce. And the average sale price for new houses sold in the United States has also rebounded over the past two years to pre-crisis peaks. Thus, we are certainly in better shape than we were a few years back when it comes to housing.

Despite these recent signs of improvement, it remains important to not get too far ahead of ourselves, as the housing market still remains in a highly fragile state. Yes, the monthly supply of homes has fallen, but it is also worth noting that the number of single-family houses for sale is still just barely off of historical lows. And while new housing starts have recovered nicely in recent years, they have bounced to levels that represented the absolute trough levels during the worst of the early 1980s and early 1990s recessions. So while progress has been made, the recovery has a long, long way to go, particularly given the persistent questions surrounding the composition of buyers driving the recent increase in demand.

Given the still fragile state of the housing market, it is worthwhile to watch leading indicators to monitor the sustainability of the recovery.

Lumber prices are one of the best leading indicators for the strength of the housing market. It is, after all, an essential product for the homebuilding industry. In short, you need a lot of lumber if you're going to build a house. Thus, if the recovery in housing is proving sustainable, it should naturally be accompanied by a commensurate increase in lumber prices. While this had been the case previously, it unfortunately has not been so in recent months. Over the last two months since mid March, lumber prices have cratered by a staggering -30%.

Perhaps the recent plunge in lumber prices is just an anomaly. After all, we have seen a number of major dislocations in commodities markets over the last year that in many cases defy not only logic but also the basic fundamentals of supply and demand. But if this decline does not begin to reverse itself soon, it may be signaling that the renewed life in the housing market may end up being fleeting in the end.

The recent weakness in lumber prices also has important implications for the stock market (NYSEARCA:SPY). Dating back to the beginning of the financial crisis, the stock market and lumber prices have traveled the long road both down and up together. While lumber prices have oscillated around the relatively more stable stock market, the path has almost always been the same. As a result, the dramatic deviation that has developed over the last few months is striking. Perhaps this recent price swing will eventually resolve itself, but it should be noted that the two previous instances where we witnessed such dramatic downside price volatility in lumber prices in the spring of 2010 and spring of 2011, it foretold a pending correction in the stock market. In this regard, it is notable that the magnitude of the price decline in lumber is even more dramatic this time around.

The implications of plunging lumber prices are even more pronounced for the homebuilding companies. Even more than the broader stock market, the direction of lumber prices and the shares of companies that are directly tied to the homebuilding industry as represented by the SPDR S&P Homebuilders ETF (NYSEARCA:XHB) have been very tightly correlated. It should be noted that the XHB not only includes major homebuilders such as Ryland (NYSE:RYL), Pulte (NYSE:PHM), D.R. Horton (NYSE:DHI) and Toll Brothers (NYSE:TOL) but also the various companies whose fortunes are closely tied to the homebuilding industry such as Home Depot (NYSE:HD), Lowe's (NYSE:LOW), Williams Sonoma (NYSE:WSM) and Bed, Bath & Beyond (NASDAQ:BBBY). While the XHB had been running ahead of lumber prices since the beginning of 2012, the recently wide disconnect that has emerged between these two readings over the last two months warrants close attention going forward.

Of course, the direction of lumber prices also has direct implications for those companies that are major lumber producers. These include companies such as Weyerhaeuser (NYSE:WY), Plum Creek Timber (NYSE:PCL), Rayonier (NYSE:RYN), Potlatch (NASDAQ:PCH), Louisiana-Pacific (NYSE:LPX) and Universal Forest Products (UFPI), among others. What makes the implications here particularly notable is that several of the companies listed above are classified as specialty REITs, which is among the categories to which yield starved investors have been flocking for the first time in recent months to try and generate income. Thus, the potential for any sharp pullback among any of these companies could present a rude awakening for those who are new to the sector and its potential risks.

Perhaps the recent disconnect in lumber prices over the last few months will end up being nothing. It has enjoyed a nice +5% bounce on Thursday, so perhaps this will mark the reversal of the downside trend over the last few months. But then again, perhaps it is not. And given the importance of lumber prices as a leading indicator not only for the health of the housing market as well as the overall stock market, this is an indicator that should not be ignored going forward.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.