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Indicator Warns a Bear Market May be Coming in This Sector

Michael J. Carr and Amber Hestla-Barnhart

Intermarket relationships, rules that explain how one market affects another, work in the long term and unfold over months.

For example, stocks and bonds are competing for investment dollars. If interest rates move up, bonds may become more attractive than stocks for some investors and stock prices could fall as investors move their dollars from one market to the other.

One of the more reliable relationships is between lumber and homebuilders.

New home sales are strong right now, but lumber prices tell us that weakness probably lies ahead. Months before a home is built, the builder will place orders to buy lumber. Strength in the lumber market should precede strength in homebuilding, while weakness in lumber signals a potential slowdown in homebuilding. That's where are now, with lumber in a bear market after falling 25% in less than three months.

Because lumber sales come before the home sale, it is very possible to have good news on home sales while lumber prices are heading down. Lumber is a leading indicator of the construction market, and right now it is saying to expect weakness in home sales 6-12 months from now.

This relationship is logical, and it can also be seen on the charts.

Lumber prices peaked three months before homebuilders in 2005. Home prices peaked about 13 months after lumber. The stock market peaked almost three years after lumber, so this is not a reason to expect a bear market in stocks. There may very well be a bear market in stocks, but lumber prices are not a reliable indicator of that.

What the decline in lumber is telling us is that homebuilders, one of the strongest groups in the market, look vulnerable to a sell-off.

We believe the best way to trade this idea is with put options on iShares Dow Jones U.S. Home Construction (ITB).

Before getting to the trade, let's look at the chart. We've added a measuring technique that isn't commonly used that we'd like to explain.

Price charts tend to display a sense of symmetry. This is the concept that traders use when they use patterns to find price targets. Price moves after a breakout are expected to be equal to the depth of the pattern. An upside breakout from a rectangle pattern, for example, provides a price target equal to the difference between the high and low of the pattern added to the high.

That same idea can be applied to moving averages (MAs). The distance prices move from the MA can be used to find the target when prices cross the MA. This technique has been applied to the chart of ITB.

At the left of the chart, the first vertical line shows that prices reached a level that was $1.66 above the 26-day MA. Subtracting $1.66 from the MA shows the price target of $21.14. The subsequent low was only $21.34 so the projection was off by $0.20. The next three target prices were all achieved and reversals followed within days. We use the 26-day MA as a default setting for our charts, but this idea works with any MA.

This technique shows a target of $21.05 for the current down leg of ITB. Traders can short ITB or use put options for this position.

Buying put options allow us to trade the expected down move without facing the theoretically unlimited risk of a short trade. With puts, the risk is limited to the amount paid for the option. With a short trade, we limit risk with a stop-loss order.

Puts expiring in January 2014 with a strike price of $25 are trading at $2.15. These options should be worth at least $3.95 if ITB reaches the target of $21.05.

If history repeats, homebuilders will follow lumber prices lower, and ITB could provide profits for traders if that happens.

Recommended Trade Setups:

-- Sell ITB short at prices below $26
-- Set stop-loss at $28
-- Set initial price target at $21.05 for a potential 19% gain in 3-6 months

-- Buy ITB Jan 2014 25 Puts at $2.50 or less
-- Do not use a stop-loss; risk only an amount you can afford to lose
-- Set initial price target at $3.95 for a potential 58% gain in 6-12 months

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