INVESTING: Slip in home-builder stocks signals market weakness

The big, bad wolf has been huffing and puffing against homebuilding stocks, and for a while it didn’t look as if he’d blow the house down. The outlook changed in early August, however, and the wolf now is seeing results.

Residential real estate became the talk

of the cocktail party circuit after the market topped in 2000. Over the next five years, the stories became more and more fantastic.

Condos in south Florida doubling in price. Shacks in California tripling. Average annual returns climbed so far above normal rates for the past 200 years that we lost all sense of reality.

Some of the biggest beneficiaries of this monster run have been home builders. Over the last five years, the stock of Ryland Group has gone from $4 to $80. Just about every other stock in the industry saw returns that were crazy under any conditions.

Today, these stocks are under pressure. For a long time, it seemed as if every time the general market would rally to a new high, home builders would rise with it.

Not so now. The S&P 500 hit a new rally high recently, but the home-builder index was 8 percent off its early-August high.

Investors Business Daily, which gauges the relative strength of 197 industry groups, now ranks builders 167, down from 157 a week earlier, 109 three months ago, and 24 six months ago.

That is serious trend deterioration, and something investors should pay attention to. The object is to make money without taking a lot of risk. Nothing else matters.

Regular readers know I’ve been saying that the current rally is probably the last hurrah for the bull market that began in March 2003. I watch more than 120 indicators every day, and more than a few of them have been in sync with my outlook.

One indicator of market health is the behavior of leading industries. Think tech stocks in the 1990s. Few of them were still climbing by the time the market tanked in 2000. It’s a red flag if a rally continues but a leading industry doesn’t join, as is the case now with home builders.

It’s also a red flag when a leading industry has far less support than it did in the recent past. If home builders are giving us one reason to worry, another group is giving us reason to lose sleep.

Energy stocks have been on a tear for three years. For a long time, XLE, an exchange-traded fund for energy stocks, saw new highs every time the S&P 500 did, and often when it did not. XLE came close to hitting a new high with the rest of the market in late November, but an interesting divergence popped up.

In early August and October, more than 80 percent of the component stocks within XLE were either at new highs or within 3 percent of a new high. In late November, however, only 12 percent of the stocks within XLE fit the pattern. I am not sure the energy stocks are done running, but for the first time in years, weakness is apparent.

When the leaders stop leading, you need to sit up and take notice. The market, in its typically subtle fashion, is giving us information we can act on. I don’t intend to turn a deaf ear.