Blog - Investing Notes

September 28, 2007 - Are Homebuilder Stocks Early Warning Indicators for Equities in General?

With reversal of the easy lending practices of 2003-2005, U.S. home sales and homebuilder stock prices have fallen dramatically (as frequently and loudly reported in the media). Does the behavior of homebuilder stocks portend doom for the overall equity market? To check, we first assemble a simple measure of the performance of homebuilder stocks as the equally-weighted average monthly return for the stocks of Centex, DR Horton, Hovnanian, KB Homes, Lennar, Ryland and Pulte, starting with Centex and Pulte in August 1985 and adding the others as they are listed. Comparing these returns with monthly returns for the S&P 500 index data for 8/85-9/07 (266 months), we find that:

The following scatter plot depicts the relationship between monthly returns for the S&P 500 index and monthly returns for our simple homebuilders index. Visual inspection indicates that the two indexes tend to move up and down together. The Pearson correlation is 0.56 and the R-squared statistic is 0.31, suggesting that the movement of homebuilder stocks explains 31% of the movement of the overall stock market. These data are coincident, so "explains" does not mean causes. Based on this historical relationship, foreknowledge of the behavior of homebuilder stocks would grant some foreknowledge of overall stock market movement.

The outlier at the extreme lower left is October 1987.

Does one index lead the other?

The following chart summarizes the relationships (Pearson correlations) between monthly returns for the S&P 500 index and average monthly returns for homebuilder stocks for various lead-lag scenarios, ranging from homebuilder stocks lag the overall market by 12 months to homebuilder stocks lead the overall market by 12 months. The peak at "0" is the coincident relationship depicted above, with Pearson correlation 0.56.

Results imply no reliable leading or lagging relationship between homebuilder stocks and the overall market.

The strongest indication other than the positive correlation for coincident movement is the negative correlation of -0.24 at -4 months, which weakly suggests that good (bad) performance by the overall stock market means bad (good) performance by homebuilder stocks four months hence. (Over the same period, the autocorrelation for monthly S&P 500 index returns with a four-month offset is -0.12.)

There is no reliable indication that the performance of homebuilder stocks predicts that of equities in general over the next year.

In summary, evidence from a simple analysis of historical stock prices does not support a belief that homebuilder stocks are early warning indicators for equities in general.

See Blog Synthesis: Some Trading Indicators for analyses of the usefulness of other technical indicators. See also analysis of the relationship between home prices and stocks in our blog entry of 6/12/07.