What Lumber's Hinting About Highs in Homebuilders

JC Parets
February 20, 2020

From the desk of Steve Strazza @Sstrazza

Thank you to everyone who responded to this week’s mystery chart.

We had a lot of "do nothing" responses this week, many of which were caveated with the fact that the structural trend is lower, thus anticipating an eventual breakdown but waiting for more data to come in to confirm it first.

We also had a number of responses with conviction to buy the test of support and plenty of others who wanted to sell into it or "look to get short." The majority took a neutral approach, preferring to see how prices react at this key level of interest before choosing a directional bias.

I think that is the most prudent thing to do in this situation as well, so with that as our backdrop let’s take a look at this week’s chart.

The chart in question was Lumber Futures, inverted and zoomed all the way out to the late 1980s. Here it is flipped right side up, which means all of you sellers and those who wanted to see the breakdown confirm before getting short are actually betting that this long-term base will be a continuation pattern, eventually resulting in higher prices.

Click on chart to enlarge view.

I am leaning towards this scenario myself but can't emphasize enough just how important it is to wait for a sustained breakout before taking any action, especially with prices pressing on a level where they have failed so many times in the past.

Prices made three major tops in the mid-'90s around 485 and another one around 460 in 2004, which was just eclipsed by current prices. If we ignore the failed breakout in 2018, Lumber is currently at its highest level since 1996. Sellers could dig in here again and it could take years to finally take out the 485 level, or it could happen next week. But until price confirms one or the other, patience is the best position.

The real reason we are watching Lumber Futures so closely right now is not to make a directional bet on them but instead for a read on Homebuilder stocks, which recently made all-time highs.

Here is a chart of the SPDR S&P Homebuilders ETF ($XHB) showing its recent breakout above prior record highs from 2007 and 2018. The lower pane shows its correlation with Lumber.

The two assets have a high positive correlation for obvious reasons so a breakout in lumber would do a lot in terms of adding to the evidence that these new highs in Homebuilders are here to stay.

On the other hand, if Lumber fails at these former highs we'll interpret it as a warning that the recent breakout in Homebuilders may be no more than a bull trap. Under this scenario we'd expect to see these stocks catch down with Lumber, confirming a failed move and the bearish momentum divergences that are in play on both weekly and daily timeframes. This would lead to corrective action and potentially much lower prices. Here is a zoomed-in daily chart of Homebuilders.

But for now, we are left only with the data in front us which is Homebuilders continuing to grind higher while Lumber pushes on the upper boundaries of a nearly 30-year range. The divergences remain unconfirmed and prices have yet to give us any reason to bet aggressively against these trends.

It's also important to remember that the correlation we're referring to is a very long-term one. The call here is not that this near-term bearish momentum divergence in Homebuilders is being caused by weakness in Lumber. Instead, it's that one of the two situations has to happen for this long-term correlation between Homebuilders and Lumber to remain intact.

Either Homebuilders will break their 2007 highs and catch down to Lumber...or Lumber will break 30 years' worth of resistance and catch up to Homebuilder stocks.

As structural market bulls, we believe it will be the latter, with Lumber eventually breaking out to new highs and the two moving higher together.

If and when that happens we'll feel much better about the new highs in Homebuilders and can be aggressively long many of the names that are clearing multi-year or decade-long bases. For now, we'll wait on Lumber and continue to use the 2018 highs near 46.60 as our near-term risk-management level in Homebuilders.

How do you think this scenario will play out? Let us know.

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Allstarcharts Team

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