Lumber Does Not Bode Well For Housing

By Stephen D. Simpson, CFA | June 18, 2010 AAA

Over the last year or so, home building stocks as measured by the S&P Homebuilders SPDR (NYSE:XHB) have had a pretty respectable run, topping the S&P 500 by about 20% or so. Of course, it must also be mentioned that this is a strong recovery off of a deep bottom, as a four-year comparison shows a painful drop of over 60% for holders of this ETF.

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Among this year-long rebound has been a muddle of mixed messages, as sentiment feels worse than the numbers look. Low interest rates and tax credits have encouraged some buyers to get back in the market, and banks seem to be reporting some stabilization. Going a step further, prices seem to be creeping up again, housing inventories have leveled off, and sales appear to be growing.

That has not really been good news of late, though, for the shareholders of stocks like Pulte (NYSE:PHM), D.R. Horton (NYSE:DHI), Lennar, or Toll Brothers (NYSE:TOL) as these stocks have all come off their highs lately. If these stocks can move unpredictably in the face of economic data, is there another data source for investors to watch?

The answer appears to be "yes".

An Eye on Lumber
While Warren Buffett says that he was not able to forecast the collapse of the housing market, it seems that there was a group of people who did a pretty good job of it - the folks who trade the lumber commodity futures in Chicago. During both the build-up, peak, and decline in housing, lumber has appeared to be a reasonably accurate leading indicator for home builder stocks. In most cases, it appears that lumber moves about two to four months ahead of major moves in the home building stocks.

That lumber and housing should be tied together is no great surprise. Roughly half of the U.S.'s lumber production is used for new housing, and 75% again of that amount is used for remodeling and repair projects, and about 90% of residential construction is built from wood. (For related reading, check out Timber Investments Cut Down Portfolio Risk.)

What strikes me as interesting, though, is that there is not a similar effect with the Claymore Global Timber Index (NYSE:CUT). In fact, this ETF of lumber and timber companies more or less tracks the home builder ETF, suggesting that there is not so much predictive power there. So while lumber for the building sector (and the paper sector as well), is the stock in trade for companies like Plum Creek (NYSE:PCL) and Rayonier (NYSE:RYN), they do move a little after commodity lumber.

Where To from Here?
Although there are some fundamental economic reasons to be optimistic that we have seen the worst in the U.S. housing market, the commodity lumber market is saying in effect "not so fast". Lumber and home builder stock prices peaked in mid-April and both have continued to fall steadily since then.

Is this a product of the expiration of the home buyer tax credit? Is it a reaction to high unemployment, relatively high existing inventories, and still-high foreclosure rates? It is difficult to say precisely why any commodity moves over a short period of time, but it is clear from the commodity markets that traders are not optimistic about seeing good news concerning new housing in the short-run.

The Bottom Line
For shareholders interested in housing stocks, that is certainly not good news. It would probably be prudent, then, to wait for an "all clear" from lumber (a bottoming/base in lumber prices) before taking any big position in a builder. On the flip side, shareholders considering timber investments may be able to afford to be a little more aggressive on a selective basis. After all, stocks like Plum Creek and Rayonier will pay reasonable dividends in the interim and those timberlands can just keep quietly growing in value while waiting for the rebound to resume. (For more, see The Value Investor's Handbook) Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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