Brutal winter weather straight out of a Charles Dickens novel has caused a sharp divergence in the price of lumber and home-builder stocks, making it difficult to discern the health of the U.S. housing market. It is reasonable to expect that the two will begin to move in tandem again in the coming months. This may create opportunities for investors.
Historically, lumber prices have been highly sensitive to changes in U.S. construction, often providing a leading indicator for profit growth in the home-building sector. Recently, the SPDR S&P Homebuilder ETF has jumped more than eight per cent since early February, while lumber futures have fallen hard.
Lumber active future contract vs SPDR S&P HomeBuilder ETF
SOURCE: Scott Barlow/Bloomberg
Weather is undoubtedly a factor in the lumber price decline. People don't usually build houses on frozen ground, for one. In addition, the U.S. lumber industry was scrambling to increase production in 2013, only to see construction activity freeze up and demand fall in 2014.
But oddly, the slowing activity has had little effect on stock valuations for the home-builder companies in the ETF. Despite strong share price performance, the average P/E hasn't budged this year at about 21.5 times trailing earnings – much cheaper than March 2013's 30 times earnings.
If the homebuilder ETF was becoming a lot more expensive in terms of price-to-earnings, it would be easier to predict a sharp fall in price. Valuations have remained stable however, which suggests they may be able to resist the gravitational pull of lower lumber prices.
The frigid weather has negatively affected residential housing construction, but the broadly positive trend remains intact. February data showed single family housing starts at 907,000, six per cent less than in February 2013.
The three months from December to the beginning of March are typically the slowest home-building months of the year. But most recently, the average number of homes built in that period was 950,000 per month – more than the average 915,000 homes built per month in all of 2013. The positive trend is even more stark in comparison to 2012, when only 760,000 homes were constructed per month.
Home-builders need a lot of lumber to maintain profit growth, so it doesn't make sense for the stocks and commodity price to move in different directions for long. However, the possibility that weather has played a much bigger role in these markets means investors should be very careful about assuming which line on our chart will move to meet the other.
The lumber price comparison with the home-builder index is a good reminder that divergences in assets with historically high correlations can be re-established in two ways. Either the top line will fall, or the bottom line will rise.
A hedge fund manager's inclination is to consider both possibilities at the same time. In this case, they'd build a short position in the home-builder ETF and a long position in lumber futures. This two-sided trade would use leverage (either through the use of futures or borrowed funds) to benefit from either a fall in home-builders, a rise in lumber or any combination of the two. The only way the trade would lose money is if the gap between the two widened.
The U.S. housing market is one of the largest asset classes on the planet at $25-trillion (U.S.) according to research firm Zillow Inc. The two steps forward, one step back progress of the U.S. economy has been maddening, and a resumption of growth would go a long way toward setting Canada's largest trading partner on a more positive course.