RECENT WEAKNESS IN HOMEBUILDING STOCKS IS A SIGN OF ECONOMIC WEAKNESS -- SO IS THE DROP IN THE PRICE OF LUMBER -- BOTH OF WHICH HELP EXPLAIN FALLING BOND YIELDS AND RISING BOND PRICES
HOMEBUILDING ETF BREAKS 200-DAY LINE... One of the more negative market signs of late has been the breakdown in homebuilding stocks -- both in absolute and relative terms. Chart 1 shows the DJ US Home Contruction iShares (ITB) well below its 200-day moving average and trading near the lowest level of the year. That makes homebuilders one of the weakest groups for the year. The group's weak relative performance is seen even more clearly in the falling ITB/SPX ratio below Chart 1. After rising from last December, the ratio peaked in early May and has fallen to the lowest level in nearly six months. Bear in mind that weakness in the housing sector was one of the main reasons that stocks weakened in 2008. Relative strength in housing stocks in the spring of 2009 helped launch last year's bull run. One has to wonder how the market can mount any kind of sustained rally given the recent slide in such an important market group. Arthur Hill wrote yesterday about new relative weakness in consumer discretionary stocks, and retailers in particular. Over the last month, three of the worst percentage losers in the consumer discretionary sector have been homebuilders, namely Pulte (-18%), Lennar (-17%) , and DR Horton (-15%). Another potential sign of the weakness in the housing area is seen in the sharp drop in the price of lumber.
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Chart 1
FALLING LUMBER PRICES REFECT SLOWER BUILDING ... The price of lumber is closely tied to the trend of homebuilding. It may be a bad sign therefore to see lumber prices tumbling to the lowest level of the year. The brown line in Chart 2 shows lumber peaking during April and tumbling since then to the lowest level since last November. The green line (ITB) shows that homebuilders starting dropping shortly thereafter. While the plunge in lumber prices may be a negative sign for homebuilding, a big drop in building activity also hints at economic weakness. Which may explain why stocks and bond yields starting dropping right around the same time.
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Chart 2
FALLING LUMBER HELPS EXPLAIN BOND BUYING... It's not a stretch to suggest that the direction of lumber prices has an impact on the direction of bond yields. If falling lumber prices imply a slowdown in construction spending (and less economic activity as a result), it stands to reason that bond yields would start dropping. And that appears to be happening. Chart 3 compares the direction of lumber (brown line) and Treasury bond yields (green line) over the last two years. As you can see, they have tended to rise and fall together. They fell together during the second half of 2008, rose together during 2009, and have been falling together since April. [Another economically-sensitive commodity which is copper (orange line) also peaked during April]. All of which may explain why investors continue to favor Treasury bonds (and most other bond categories) over stocks. They sense economic weakness. Recent strength in the U.S. Dollar (and weakness in most commodities outside of gold), also have a whiff of deflation which also favors fixed income assets over stocks.
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Chart 3
BONDS VERSUS STOCKS... Unlike Treasuries, corporate bonds usually trend in the same direction as stocks. That's because corporate bonds are more influenced by credit quality of corporations (while Treasuries are more influenced by the direction of interest rates). Corporate bonds and stocks don't always rise and fall at the same rate however. They compete for investor preference depending on the state of the business cycle. Chart 4 is a ratio of the Investment Grade Corporate Bond ETF (LQD) divided by the S&P 500. It shows that stocks did better than bonds from 2003 to mid-2007 as stock prices rose. Bonds did better from mid-2007 to spring 2009 during the financial crisis. The pendulun swung back to stocks from spring 2009 to spring 2010. It now appears to be swinging back to bonds. Chart 5 shows the ratio of corporate bonds to stocks turning up this spring. It appears that investors aren't buying the argument that the economy is getting stronger and still prefer fixed income categories over stocks. It's hard to say whether recent weakness in housing (or lumber and copper) has anything to do with that. But it probably does.
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Chart 4
