A Possible Early Sign of a Market Rebound

Last week, stocks fell sharply. The S&P 500 ended the week down 5.16% in price. The Lark Research Homebuilder Stock Price Index fell 6.02%, underperforming the broader market.

At this point, it is too early to call a market bottom. The stock market could conceivably have already put in a bottom here; but technical analysts almost always want to see some stabilization in share prices (and perhaps a retest of the lows) to put the probabilities in their favor before confirming a market bottom. Those who buy here are usually seen as trying to catch the proverbial “falling knife.”

Those analysts who are willing to make a bold call in these situations often do so with the support of positive signs from other areas of the financial markets, including positive signs from sectors that typically lead the broader market. One possible sector is the homebuilders, because housing is a leading indicator of the economy. The data that I have on the homebuilders do not yet confirm an upturn, but there was one positive sign in last week’s sell-off that suggests that a rebound may not be that far off.

Homebuilding stocks had an exceptionally strong year in 2017. My Homebuilder Index was up 61.1% for the year, much better than the S&P 500’s 19.4% and Russell 2000’s 13.1%. Prior to 2017, homebuilding stocks had traded sideways for four years. After more than doubling in price in 2012, the stocks had to grow into their high valuations.  This time around, however, homebuilder stock are not nearly as high following their sharp advance.  In fact, they are roughly in line with historical averages in the low double-digits.

After such a sharp run-up in 2017, which allowed the homebuilders to catch up to the broader market (see chart above), a correction was not unexpected. The Homebuilder Index peaked in mid-January, two weeks before the broader market. It is now down 17.8% from its peak and 13.3% since the peak in the broader market. By comparison, the S&P 500 is now down 8.8% from its peak and the Russell 2000 is down 8.1%. (Please note that these percentages are calculated off of weekly closing prices.)

Last week, the Homebuilder Index fell another 6.0%, still worse than the drops of 5.2% in the S&P 500 and 4.5% in the Russell 2000. At this juncture, there is no clear evidence that a bottom is at hand for either the homebuilders or the broader market.

Yet, a potential early sign of a bottom comes from the high yield market. A mini-index of homebuilder bonds that I have compiled – consisting of seven bonds of seven large builders (DHI, KBH, LEN, MDC, NVR, PHM and TOL) with credit ratings ranging from BB- to BBB+, was up slightly last week, gaining 0.4%. By comparison, the iShares iBoxx High Yield Corporate Bond ETF (HYG) fell 1.5%. Other high yield bond indices suggest that entire universe of homebuilder bonds fell, but by less than the broader high yield market. Stronger performance for more highly rated bonds is a positive (but admittedly tentative) sign for both the sector and the broader market.

Growth in sales and profits will most likely continue for the homebuilders in 2018.  Average net new orders for the calendar fourth quarter were up nearly 16% vs. the prior year for ten of the twelve builders that I follow that have reported so far. It is unlikely that the housing market is at or past its peak.

Even so, the broader market has probably not yet bottomed. Many market watchers see this recent market swoon as a potential challenge for new Fed Chairman Jerome Powell, who reportedly favors continuing the interest rate normalization process. If so, the drop has apparently not yet worried one outgoing FOMC member, NY Fed President William Dudley, who called it “small potatoes.”

Market technicians will be watching to see whether the S&P 500 holds above its 200-day moving average. It bounced back sharply on Friday after touching its 200-day average. If the S&P 500 fails at its 200-day, then Fibonacci retracement analysis may offer a guideline for the next level of support. Pegging the start of the recent advance from the last meaningful market correction which ended in February 2016, Fibonacci analysis suggests that the S&P 500 could drop another 6%-16% to 2500-2200, before bottoming.

February 12, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036

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