For a few years now, I have been employing lumber prices as a leading indicator for what the homebuilding sector of the stock market would do, and it has worked pretty well. But lately the correlation is broken, with housing stock prices falling even as lumber said they were supposed to continue trending higher. So it’s time to reevaluate the hypothesis about lumber giving a leading indication.
In the past, I have found that a lag time of just over a year worked to show how the HGX’s movements tended to match the earlier ones in lumber. That is the correlation which has broken down recently. So I decided to see if perhaps the lag time had changed, or perhaps something else is going on.
Playing around with different lag times, I came up with this week’s chart shown above. It features a lag time of only 55 trading days, which is about 2-1/2 months. For most of the period shown in this chart, this relationship seems to work, although the alignments of the highs and lows in each plot are not perfect. Sometimes it seems like a longer lag time would work better, sometimes a shorter one. 55 trading days seems to get the best overall fit.
That is, up until February 2018, when the relationship breaks down. That was the point for the HGX plot that is equivalent to when lumber futures prices went up above $450, and that seems to be what “broke” the correlation.
Generally speaking, the conditions which are supportive of higher lumber prices are the same conditions that are good for the homebuilders. When demand is rising for new housing units, the builders can build more of them, and also charge a higher premium on the ones that they are able to build. More building means more demand for lumber, which makes sense. So that’s why it is not farfetched that there would be a relationship between the two.
Evidently that relationship has reached a breaking point, similar to how a higher nose-up angle in an airplane means more lift, right up until you hit the stall angle. Anyone who has ever had a flying lesson in a small plane has learned about the stall angle, and what happens when you exceed it – – you pull back on the yoke, but the nose goes down.
That is a good analogy for what is happening now with lumber and housing stocks. For a while, the rise in lumber was a good thing, indicating strong housing demand. But the lumber went too far, and is now squeezing the homebuilders’ profits more than they can make up with higher pricing. Or at least that seems to be the market’s interpretation, as the homebuilding sector stocks are moving lower, and to a greater degree than the overall stock market.
Having a leading indication like lumber is great; I always like something which can tell me the answers ahead of time, even if they are not perfect answers. But we have to remember when using them that mysterious market physics can arise once something gets to a breaking point, and thereby ruin our nice crystal ball. So for now, lumber’s message for homebuilding stocks is not useful, and not to be trusted. The interesting question will be whether it starts working again once lumber drops back down through that $450 stall level (assuming it ever does).
Editor, The McClellan Market Report