Upon becoming a broker and research analyst in the early 1990s my mentor taught me to watch one sector of the market as a leader… the homebuilders.
According to Andy, the market always did better when the homebuilders were doing well and stocks suffered when the homebuilders suffered. It’s a leading sector for the market.
Look back at time, and he’s right. The homebuilding sector is one of those “canary in the coalmines” that you always keep an eye on. Activity in this group of stocks can make or break the rest of the market with the implications that they subtly send.
Sure, the Semiconductor sector is one of those sectors that tend to lead the market.
The reason for that is relatively simple. A strong economy means that we’re buying more “things” and there are very few “things” that don’t have a semiconductor chip in them today.
Note that the semiconductor sector ETF (SMH) is choppy at best and has been trading without a strong trend for the last nine months. It’s something to keep an eye on, but for now we’ll focus on the homebuilders.
Tracking the homebuilders gives a more robust read of the economy, and that “read” is starting to suggest that investors should prepare for some tough times in the market.
In late 2024, potential homebuyers were starting to warm-up to the housing market.
Interest rates looked as though they were going to fall in 2025 and the labor market were forecasted to remain strong. With money in their hands and rates coming down, would-be homebuyers were preparing for the buying season – which typically runs from February through June – to be one for the books.
But things have changed over the last two months.
Interest rates shifted higher in January in response to President Trump’s tariff initiative.
Today, interest rates are 28% higher than they were on October 1, meaning that homebuyers are once again facing mortgage rates that are approaching their October 2023 highs.
Housing prices, which were expected to drop slightly due to new inventory coming onto the market have remained elevated.
Existing homebuyers have hunkered down to hold on to their homes, adding even more uncertainty to the housing market.
And finally, the tariffs. The proposed 25% tariffs against Canada would affect the number one material that homebuilders need, lumber.
As of 2023, the United States imported roughly 40% of its homebuilding lumber, 85-95% of that coming from Canada. A 25% tariff – that could go even higher – on that lumber would flow through to the bottom line of new home construction immediately, once again inflating the price of new homes in the market.
It all adds up to a bearish situation for the homebuilders and a trickle-down effect on the economy.
Homebuilders have spent the last week lowering the market’s expectations.
Just this week, Toll Brothers (TOL) missed its earnings estimates, resulting in the company’s stocks falling more than 8%.
One of the reasons for the earnings miss, the expenses of offering incentives to homebuyers to keep their inventory moving, something that many of the homebuilders are beginning to curb.
Lennar (LEN) had the same results and outlook in December.
The company missed earnings by $0.12 following weaker revenue as a result of would-be homebuyers pulling back on their expectations to buy due to higher prices.
Over the last year, existing home sales have made up roughly 2/3 of the month home sales.
Last month, existing home sales saw an increase following a slight drop in interest rates. Homeowners looked to move fast while rates were lower.
Today, mortgage applications for existing homes dropped
The existing home market has been iced over as homeowners have become fearful that prices and interest rates are set on their course higher through 2025.
Higher rates have left existing homeowners happy to stay put in their homes, eliminating a large portion of the affordable market for houses.
The homebuilding sector has been nearing its first long-term bear market since February 2022.
Shares of the S&P Homebuilding ETF are trading just 3% above the line between a bull and bear market trend represented by the ETFs 20-month moving average.
That moving average is also sitting at the $100 price, one of the most significant psychological prices on the spectrum for a stock or ETF.
Round numbers are the most identifiable “barometer” for a stock or ETF. For that reason, investors react to moves above and below the $100 price point with buying or selling interest. In this case, a move below $100 will be a negative for the homebuilding ETF.
More importantly, the long-term 20-month moving average.
This long-term trendline is used as the line of demarcation between a bull and bear market.
The homebuilder ETF slipped below this long-term trendline in February 2022. At that time, the XHB had lost 21% from its December 2021 highs. Today, the XHB shares are trading 20% below their November 2024 highs.
Going back to the original lesson from Andy, the homebuilding sector is the leading sector to watch.
The last bear market from homebuilding stocks timed up almost perfectly with the beginning of the last bear market for the S&P 500.
Today, the S&P 500 hovers nearly 20% above its 20-month moving average, suggesting that any bear market for stock would be much deeper and painful than what we experienced in 2022. That said, the S&P’s distance from its long-term trendline does suggest that the market is well overdue for a “healthy correction” in stock values.
As of today, momentum and volatility measures suggest that the market’s rally is running thin.
Volume on the Nasdaq 100 (QQQ) and S&P 500 ETF (SPY) have been on a steady decline, suggesting that investors are slowing their investments into stocks while market valuations have stretched. This, as stocks enter their third year of a strong bull market run.
A move below $100 for the Homebuilders ETF (XHB) will serve as the warning shot that retail and other consumer discretionary stocks are heading for a slump.
Mix that with any sign of inflation in the February Cpi and PPI reports to be released in three weeks and we’ve got the trigger for the market’s technical stumble.
Preparing for a valuation correction like this is relatively simple.
By setting the exit and new entry prices for positions in your portfolio ahead of the coming volatility you take the emotions – and missteps that come with trading emotions – out of the equation. This often results in improved portfolio management and returns.
