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Introduction: Homebuilding stocks are closely followed not only out of direct interest in the sector but for clues as to the course of the economy. The builders are commonly tracked via the iShares Dow Jones US Home Construction Fund (ITB). A broader view of the housing market is also achieved via a different ETF, the SPDR S&P Homebuilders ETF (XHB). These ETFs are valuable tools for investors, given the importance of housing to the broader economy. They have defects, as well, including only 7-year trading histories and variable levels of dividend payouts that over time mean that total returns begin to differ from the movement of the raw indices themselves.

In addition to those well-known ETFs, I believe that tracking the price of lumber itself is useful in different ways. Of course, the major use for lumber and other wood products is in construction, primarily domestic but also for export to China and elsewhere.

Lumber and other wood products may be earlier leading indicators than housing-related stocks. What follows are first some observations about lumber and wood product (e.g. fiberboard) prices, then comments on housing stocks, focusing on ITB and certain individual builders.

Lumber prices: These can be followed at least in two ways. The CME Group trades lumber futures. These are 2" X 4" random length lumber and measure dollars per thousand board feet. Lumber futures are generally lightly-traded. FINVIZ allows us to see the data:

As we see, lumber prices took a large fall this year, and are churning. The main driver of these prices is demand within the U.S., versus supply from U.S. and Canadian production. I was interested in whether this year's drop in prices might correlate with a coming drop in stock prices of at least 10% at some point. The 5+ year FINVIZ look at prices allows a tentative answer:

Going back to 2008, each time lumber prices took a major hit, important stock market sell-offs were noted, generally with a lag time. In 2008, prices had already fallen (to be shown later), but were rallying after the Bear Stearns bailout and the positive Q2 GDP report, but then took a dive before the Lehman disaster.

In 2010, lumber and stock prices peaked at about the same time.

In 2011, lumber prices peaked well before the stock market.

Last year, perhaps in a favorable portent of upcoming stock market strength, lumber had no material sell-off. This year's price drop has been large and sustained. Let's look more deeply at it.

A trade journal, Random Lengths, allows the public to see a small amount of data weekly. From its Aug. 23 edition:

Random Lengths Framing Lumber Composite Graph

These show a general weakening trend, though no collapse. Please see commentary (not excerpted) on the link above and additional data that is presented there.

Given how low interest rates were into May, I am surprised that wood prices broadly peaked just as Q1 was ending, well before the "taper" episode.

Here is a longer-term look at lumber prices (h/t EconMatters/Zero Hedge) from February of this year:

(click to enlarge)

Now the historical pattern becomes more evident. The current cycle looks suspiciously like those that followed the 1990-91 and 2001 recessions. A few years after the recessionary spike bottoms in lumber prices, a spike top over $400 has been seen several years after the recessionary bear market ended. These are the 1995-6 and 2004-5 spikes. Subsequently, by the time lumber prices then collapsed to below the rising 200-day moving average (green line), which clearly happened this year (though not shown due to the graph being made in February), it was late in the day for the stock market. A decent selling point was already in, even if the top was not.

The main variability in lumber and other wood product prices derives mainly not from sudden changes in supply but in demand for housing and other construction materials. This could explain why lumber prices dropped well ahead of stock prices in 2011. As the FINVIZ multi-year chart shows, lumber peaked around $325 early in the year and stayed in the $225 range for months. At midyear, the Fed exited QE 2 and promptly found that the economy was weaker than it feared. Soon enough, the Fed felt compelled to begin Operation Twist to aid housing, and lumber prices and stock prices both bottomed. Might this year's early peak and big fall in lumber prices be a warning that the underlying economy remains weaker than expected, as in 2011?

I believe that it's fair to say that the sharp drop in lumber prices this year of about 1/3 from peak to trough is a negative sign for stocks, though of course it's not of undue importance. History since 1990 also suggests that this year's sustained drop in lumber and wood product prices is consistent with an aging but not terminal stock bull market.

Housing stocks: These are of great interest in this discussion. The chart of ITB looks like this (the XHB is similar):

Chart foriShares Dow Jones US Home Construction (<a href=

Just looking at this chart with no knowledge of what asset is being charted, my eyes look at this bearishly. I come up with a downside target that represents support where resistance was when the asset was exiting the crash. Thus a collapse to around $14 would not surprise me. (Others may see things differently.)

A sharp bear market from today's depressed levels is not unthinkable. After all, Toll Brothers (TOL) is trading at almost 40X expected current FY earnings. NVR (NVR) is around 17X expected current FY earnings. Neither TOL nor NVR has ever paid a dividend. PulteGroup (PHM) has seen earnings estimates for its current year slashed and is now at 15X expected earnings. It has a nominal (and insecure) dividend yield of 1.2%. None of these stocks has any special book value support, either, though they are not badly valued. (An old dictum that may still be valid was to buy homebuilding stocks at or below 1X book and sell them at 2X book. This is because the book value is basically the homes and land under development, and in the Old Normal builders did not lose money very often building homes.)

Also, within the past 6 months, there was no insider buying in TOL or PHM, while there was one insider buy at NVR.

Housing stocks tend to trend, so given high P/Es and non-compelling support from book value, I'm tactically bearish on them right now in this rising interest rate environment. However, I also suspect that if a renewed bear market occurs in these stocks, it will be a great buying opportunity. The time is not ripe to buy in my view.

No one indicator can predict an entire market. However, the fact that lumber prices have been unchanged for 20 years and that the ITB and XHB would have peaked in 2005 (had they been formed yet) and remain A) depressed and B) at risk of dropping a good deal further continues to remind me that downside risks to stock prices overall are high and unquantifiable.

Conclusion: Immense efforts have been made to help the housing market heal. Given this, it should be disconcerting to bulls on the economy that lumber prices suffered a 1/3 off sale and that housing stocks have re-entered an unexpected bear market. When these have been seen in economic cycles since 1990 several years out of a recession, it has not marked the top of the economic cycle or the top of the stock market. However, in the fullness of time, an investor who exited stocks when lumber had entered a bear market this far from the bottom of a recession and went to cash was eventually rewarded with low-risk entry points in a subsequent bear market setting.

Stock market investors may be wise to avoid housing-related equities and perhaps focus on non-interest-sensitive sectors such as tech, commodities and cyclical industrial stocks. Given this year's bear markets in lumber, wood products, and housing stocks, the possibility that the stock market as a whole might suffer a sharp downdraft soon, as in 2011, may be worth considering.

Source: Why Lumber Prices Matter For Stocks, With Comments On Housing Stocks

Additional disclosure: Not investment advice. I am not an investment adviser.