Homebuilder Sentiment and the Stock Market

Statistical researchers today enjoy many advantages over their counterparts of even a decade ago.  Computers are more powerful and large datasets more available.  Software for analysis and charting has also become more powerful and easier to use.

There is a lot of irony in these developments.  The software has become so easy to "use" that the researcher no longer needs to understand basic principles to get results.

In the investment world, this takes the form of scores of misleading systems, charts, and tables, all purporting to show a relationship that does not really exist.  The process of extracting information from data, or data mining, requires great skill if the results are to be meaningful.  Since the untrained analyst takes all of the data and examines thousands of different possible relationships, something will always turn up.  Statisticians call this "data dredging".

Sometimes it is not obvious that hundreds or thousands of combinations have been tested.  This is particularly true when the result is a graph showing what appears to be a compelling relationship.  In the investment world, these graphs appear all of the time.

Reader "RB" offered an interesting comment about the relationship between homebuilder sentiment and the stock market, pointing us to a chart showing the relationship.  Take a look at the article at Calculated Risk, a site with plenty of good information on housing.  The author does a good job of showing how looking at more data dramatically changes the picture.

Frequently, even if the relationship holds up over time, it is spurious.  This is a statistical term meaning that both of the variables shown are the result of some other cause.  In this case, one might hypothesize that something good (the economy perhaps?) led to similar action in both homebuilder expectations and stocks.  By adjusting the scales and the lead time, the relationship can be made to appear even stronger.

Regular readers may remember that we did a similar analysis last September.  Take a look for another example and further explanation.

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  • RB February 6, 2007  

    Am glad to make it to the front page :). Anyway, the context I brought it up was with regards to the Fed model which intuitively makes sense — should I put my money into stocks or bonds despite the fact that forward PE averages around 12. At the same time, forward earnings are available only for the period of falling interest rates and the relationship fails for trailing earnings if you go back more than fifty years (I understand financial markets have changed and so on). So today, the persistent undervaluation may (and I may be eating my words before summer is out) be due to a higher risk premium demanded from stocks since the question asked today is not just “stocks or bonds” but also “stocks or gold”.

  • oldprof February 6, 2007  

    Hi RB
    Thanks for your comment. I do understand the original context: Does this affect the Fed model? Your question is a good one, and I’ll try to answer, at least a little.
    I have several more posts on my writing agenda for the Fed model, so I’ll be covering these topics in more detail.
    For now, I’ll suggest where I am going. As to the direction of interest rates, there is no logical reason why it should matter, since the ten-year subsumes the “strip” of forward rates. But it might matter to the market. There is still a “don’t fight the Fed” mentality– even when the rates were moving from extremely low to neutral. Arguably, they are only mildly restrictive at the moment.
    I am going to take up various efforts to “tweak” the Fed model and show some of the problems.
    I do have some criticisms of my own, relating to variables left out of the model, and the overall range of applicability.
    Having said this, I am very comfortable with the idea that stocks are undervalued, even if rates rise a bit more — something I think is likely.
    Developing this theme takes time, and it is mostly an after-hours thing for an active manager:)