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Have building stocks been set up to take a tumble?

The housing construction cycle looks set to accelerate in 2014, the question for investors is by how much? With the general view for Australia’s economy suggesting weak growth and rising unemployment, coupled with concerns regarding the health of the Chinese and US economies, the overall economic outlook appears muted which could ultimately weaken the demand for housing construction.

Over the past year a number of building-exposed stocks have recorded significant share price rises. Building materials supplier CSR Limited’s (ASX: CSR) share price is up 46%, while paint manufacturer DuluxGroup Limited’s (ASX: DLX) share price is up nearly 29%. For comparison the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) has risen just 8.4% over the same period.

The rise in share price is of course justified if earnings growth follows (or if the stocks had been undervalued to begin with). According to Morningstar’s data, CSR is forecast to more than double earnings per share (EPS) in the current financial year, which ends on 31 March 2014 – judging by its interim results of 7.2 cents per share (cps) that should be achievable. Assuming CSR meets consensus EPS of 13.6 cents per share (cps) then the stock currently trades on a price-to-earnings (PE) ratio of 21.3. Meanwhile Dulux Group is forecast to grow earnings by 14.7% to 28.9 cps which equates to a forward PE of 18.6.

The issue for investors is that solid growth rates are assumed to continue into FY 2015, if this fails to eventuate then the multiples these stocks are trading on may be hard to justify also.

One exception could be Brickworks Limited (ASX: BKW). Brickworks’ share price has rallied 14.4% in the past 12 months but there are other issues at play to support its forward PE of 19.6. The activist moves by fund manager and substantial shareholder Perpetual Limited (ASX: PPT) to break up the cross-shareholding with Washington H. Soul Pattinson and Co. Ltd (ASX: SOL) could continue to support Brickworks’ share price even if the sector experiences a correction due to revised expectations.

Foolish takeaway

The building industry is notoriously cyclical however that doesn’t mean it has to be either a ‘smooth’ cycle or that it need follow the trend of previous cycles. What we could be witnessing in Australia is a pick-up in demand that will be weak and lethargic. Demand may drop away as other issues such as job security and macro-economic concerns come to the fore, before an eventual pick-up in volumes more in line with previous cycles.

The above scenario could take years to play out, which could mean many stocks that have rallied in preparation for a construction boom lose steam. If this led to a correction in prices a potentially much more appealing entry point for investors could present itself.

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Motley Fool contributor Tim McArthur owns shares in CSR Ltd and Perpetual Ltd.