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Timber! Watch Out for Falling Lumber Prices

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Given lumber's steep decline over the last two months, it may be time to get out of homebuilder stocks as they likely won't stay this disconnected from lumber prices for long.

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First it was Doctor Copper. Now it's Lumber.

In an article I recently wrote, the focal point was copper, its historical relationship with the health of the overall world economy, and its currently bearish chart pattern. The takeaway was that copper has been declining since 2011, suggesting an economic slowdown and potentially deflationary scenario.

Commodities are in the midst of a five-year slump. Energy-related commodities, industrial metals, along with wheat all peaked in price in 2008, but have yet to revisit those levels.

A Better Leading Indicator?

Copper used to be considered the leading indicator for the world's economy, but since 2011 its price has fallen even as world stock markets climb.

Which will prove correct: copper or the equities market? Perhaps stocks are disconnected with reality, or perhaps fundamentals are better than copper is suggesting. Either way, mixed signals abound.

Another leading indicator, lumber, is known as the barometer for the housing market. When lumber prices are in an uptrend, typically so are housing builds, home prices, etc. Lumber prices have been very strong over the last five years, having turned up in price in early 2009 and making new highs recently. This has helped buoy the homebuilder equities as well.

But that all changed in March.

What about lumber?

If you believe the media headlines, then all is good with the housing sector.

The latest confidence data shows a big rise from April to May. But this, along with most fundamental data, is more a coincidence than leading indicator. It also should be noted that homebuilder confidence came in at 44, which suggests negative sentiment (any reading below 50 is considered negative). Oh, by the way, the last time homebuilder confidence was actually above 50 was April 2006.

We prefer using leading indicators, not coincidental ones.

Lumber has had an extremely strong correlation with housing stocks as the chart below shows. With a correlation of .90, lumber prices and homebuilder stocks rise and fall similarly day in and day out.

This extremely correlated relationship likely makes it the better leading indicator for the homebuilders and equities markets.



Red Flags

There are warning signs now showing up in the lumber market.

Lumber has taken a cue from copper, precious metals (NYSEARCA:GLTR), and the other commodities, falling over 20% the last two months. Is this a sign that homebuilders, the housing market, and the equities market as a whole are finally about to roll over?

Looking at the last few months shows the collapse in prices of lumber. Meanwhile, homebuilder stocks continue upward. The last time these two highly correlated markets became this disconnected preceded the 2011 market top that sent stocks down over 20%. How long will this disconnect last?



Ways to Take Advantage

One market which is closely connected to both commodities and equities is the US dollar, which has actually shown strength since the 2008 market lows and more recently since the recent commodities peak in March.

We were able to take advantage of a rising dollar as commodities warned of deflation, while dollar sentiment was reaching bearish levels. Just as the technicals were setting up a high probability trading opportunity, we wrote on Feb.10:

"The US dollar has already broken out of its downtrend channel and provides a buy signal in the PowerShares DB Bullish Fund (NYSEARCA:UUP) or in the PowerShares DB 3x Levered Long (NYSEARCA:UUPT)."

How did it work out? That trade was good for a 10% gain in UUPT. And just when you thought the best was over, another dollar opportunity outlined may again be on our doorstep.

Lumber may turn out to be the new copper in our consumer and housing driven economy.

Given lumber's steep decline over the last two months combined with the many other warning signs we follow, it may be time to get out of homebuilder stocks as they likely won't stay this disconnected from lumber prices for long.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Household Debt Down, Margin Debt Up

Are Rising Correlations a Threat to Your Portfolio?

Three Ways Income Investors Get in Trouble
No positions in stocks mentioned.
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