Jul 24, 2014 Investment Education – How to buy stocks – When is a news item good or bad?
The investment landscape is always changing. In an earlier post, I said that a rise in the price of lumber may be good for homebuilder stocks on one occasion, but might be a negative indicator in a different set of circumstances. A reader asked me how I would know which. First, in investing, you never “know”. But from experience (years of watching is best, but reading history carefully is also good) you will be better able to make consistently good investment judgments. But because history never repeats itself exactly, remember that what we are looking for here is how to make investment judgments. We are not looking for a decision rule that is sure to work ever time. (You won’t find it.)
Let’s look at homebuilder stocks. In a recession, new home building typically declines. With fewer homes being built, there is less demand for lumber, so the price of lumber falls. As the economy begins to recover, new home building begins to recover, increasing the demand for lumber. This increased demand will lead to higher lumber prices in the commodity markets (which you can watch in Investor’s Business Daily, or by doing a search for “commodity price of lumber”). The higher lumber price may be the first visible indicator of increased demand for new homes. This in turn will lead to higher earnings for most large home building companies. Just as important, the improved business reduces the likelihood that some homebuilders will go bankrupt. In a recession, when it is not clear how deep or long the recession will be, homebuilder stocks generally fall to very low valuations because in the event of bankruptcy, the stocks can go even lower with little or no likelihood of recovery. Some investors will be unable to live with this bankruptcy risk and will sell the stocks at any price, eventually forcing the price down to some level well below the company’s long term “value.”
As homebuilding picks up, signaled by the rising price of lumber, the bankruptcy risk declines, so the selling pressure on the stocks decline. Similarly, with the stocks so deeply depressed, the possible upside recovery in the stocks is so great that other investor will begin to buy the stocks, even without knowing if, or how soon, and to what degree, homebuilding and homebuilder company earnings, and therefore homebuilder stocks, will begin to show meaningful recovery. But because the stocks look so “oversold” and the upside is so great, some investor will take this risk even though the parameters of the recovery are not yet visible. So here is a case where an increase in the price of lumber is a positive indicator.
A few years later, a rise in the lumber price might mean something different. Let’s say the economy has recovered and new home building and other aspects of the economy are strong and expected to continue that way. In all likelihood, the commodity price of lumber is now at a much higher level than it was during the recession. At this point, a further rise in the price of lumber may be a negative indicator for homebuilding stocks for a couple of reasons. First, the increasing price of lumber might indicate a pickup in inflation, which often occurs late in an economic boom. In a period of inflation, most construction costs will go up, not just lumber, (although lumber as a “sensitive” indicator may be one of the first costs to rise). These higher costs will negatively impact homebuilder company earnings, which usually puts pressure on the stocks. In fact, homebuilders may be able to pass on the increased construction costs to the buyers of the new homes, and maintain their profit margins. But now, in a strong economy, homebuilder stock prices are higher, stock price valuations look richer (higher), and while further stock price increases are possible, they seem less likely, and certainly won’t be a large in percentage terms. And if the economy should slow down and home building turns down, taking company earnings down with it, the stocks will now have a long way to fall. The reward/risk ratio (upside/downside) now looks very different than it did a few years ago at the bottom of the recession.
There is also a “big picture” negative here. In a strong economy, or perhaps an overheated economy (don’t ask me to define that), the Federal Reserve bank, fearing inflation, will “step on the brakes” of the economy, i.e. try to slow the economic growth to a sustainable, non-inflationary rate. One of the Fed’s policy options is to raise interest rates, which usually has the effect of slowing the economy. Rising interest rates, however, lead to higher mortgage costs for home buyers. With higher mortgage costs, the price a home buyer can afford to pay for a new house goes down. This in turn squeezes the homebuilder’s profit margins as they cannot recoup the rising construction costs.
So in this case, the rising price of lumber is likely a negative indicator, signaling the possibility of inflation, lower company profits, and higher interest rates in the economy. The latter, in turn, increases the probabiliity of another recession. Again, none of this may happen, or at least not for another few months or years, but in this set of circumstances, the downside risk in the stocks, and the increased probability of a slowing economy, make selling the homebuilder stocks the safer thing to do.
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