Homebuilders just posted their worst day in three months. Here’s what lies ahead

Warning signs are cropping around home construction stocks.

A popular homebuilder-tracking ETF, the ITB, posted its worst day in three months on Tuesday, led to the downside by D.R. Horton. This comes on the heels of surging Treasury yields, which traditionally hurt housing stocks.

With the notable rise in the 10-year Treasury yield, mortgage rates have also moved higher. When you combine this with the disappointing earnings results out of Home Depot, this raises concerns about homebuilding stocks.

Key levels to watch

The ITB was already underperforming the rest of the stock market. In fact, it has spent most of the past 2½ months in correction territory and now stands 18 percent below its January highs.

Even more critically, it is testing the key $38 support level. It has tested this line many times since early March, so if it finally breaks below that line in any meaningful way (which would also take it below its 200-day moving average), it would be quite negative for the group.

Housing in focus

The reason why I'm so focused on this group, and its reaction to higher interest rates, is due to the debate around whether the level on the 10-year yield will have a meaningful economic impact.

Most market watchers are saying the meaningful level to watch is 4 percent, with 3.5 percent as the level many are citing to the lower end. However, if a move above 3 percent hurts the homebuilding stocks, as we have witnessed, this would indicate that a rise to a much lower rate was already having an impact.

Let's face it. The stock market tends to be a leading indicator for the economy. If the housing stocks (which are of course very important to the U.S. economy) break down and move into bear market territory, this would not be a good signal for economic growth in the second half of the year.

That's not to say a breakdown in the group would mean we're headed toward a recession, but it should indicate that growth will not be as strong as consensus may think right now. Therefore, this would be a signal in our minds that investors should consider shifting their portfolios to a little bit more defensive stance.