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The price of lumber has quadrupled from a year ago. Or, in the words of investor Michael Gayed, "it's gone the way of bitcoin."
Indeed, as May and July lumber futures on the Chicago Mercantile Exchange reached a record high of above $1,600, even crypto exchange FTX entered the game by launching a lumber futures market on Thursday.
The historic boom in lumber has had almost the same twists and turns as stocks and other risk assets since the onset of the Covid-19 pandemic. Despite the initial fears of an economic depression, lumber has become a hot commodity as urban dwellers fled cities to buy homes and homeowners took on renovation projects.
Amid an unexpected housing boom, the supply shortage caused by the shutdown of many sawmills during the pandemic has become even more acute. According to the National Association of Home Builders, the soaring price of lumber has added $35,872 in extra costs to an average new single-family home.
The supply-and-demand dynamic has also propelled lumber-exposed stocks to new highs as some investors see sawmills respond to the shortage by ramping up production, but others are less sanguine about the situation.
"If I look at the lumber futures continuous contract going back to 1980 versus what's happened in the past six to seven weeks, this looks stupid," Gayed said in an interview. "This is absurd. There's nothing that justifies this."
Lumber-to-gold relationship has reached pre-GFC levelGayed manages the $25.8 million ATAC US Rotation ETF (RORO), which uses the price of lumber relative to gold as a trigger for risk-on, risk-off conditions in the stock market.
The risk trigger draws on the findings of an award-winning paper that he published in 2015, which examines the price relationship between lumber and gold as well as how it can serve as a signal for when to play offense and defense in the stock market.
In a nutshell, the paper finds that when lumber outperforms gold, stock market volatility is generally pretty low at around 12.5%, on average; when gold outperforms lumber, the volatility in the S&P rises quite a bit to an average of 17%.
Therefore, risk-on is lower volatility when lumber is doing well against gold; risk-off is higher volatility in the stock market when gold is doing better than lumber.
"It's important because it's in these higher-volatility periods where you tend to have the accidents in the stock market, where you tend to have the major crashes, corrections, and bear markets," he said. "They tend to occur when gold is outperforming lumber, not the other way around."
Needless to say, lumber has been outperforming gold in the past few months, but that does not mean all is well in the market. On the contrary, Gayed finds that the relationship of lumber against gold has hit the same level as it did during the final phases of the housing bubble in 2005 and 2006.
"It's a sample size of one but the fact that that spread has gotten to a point where it's reminiscent of the housing bubble is a little ominous," he said.
The bullwhip effect in supply chain shortagesAnother thing to consider in the lumber shortage situation is something called the bullwhip effect.
Deutsche Bank strategist Luke Templeman explains that such an effect "occurs when a drop in customer demand causes retailers to under-stock. In turn, wholesalers respond to a lack of retail orders by understocking themselves. That then causes manufacturers to slow production. Eventually the reverse occurs."
This is increasingly relevant to lumber because as prices continue to skyrocket, home buyers and owners have started to consider delaying their purchases and renovation projects. Contractors, who are hired for a fixed price, have also begun to "slow play" the construction process in the hope of getting fatter margins in the future.
"They may have signed the contract but they don't want to get creamed on now buying much higher lumber prices," Gayed said. "So what does that mean then for economic and housing activity? It means the price of lumber starts causing people to rethink using it."
Already, soaring wood prices have hurt businesses that cannot pass on the higher costs to the end consumers, and this dynamic of supply chain shortage is taking place in everything from semiconductors to commodities including lumber, steel, copper, and cotton.
"With lumber acting the way it has and commodities in general acting the way they have, in terms of the speed with which they've gone higher," he said, "it could unequivocally be the case that this is actually going to cause a meaningful slowdown in economic activity despite everything looking very rosy."
If lumber crashes, stocks might be nextIn Gayed's view, the signs of cracks have already started to show in the bond market.
The iShares 20+ Year Treasury Bond ETF (TLT), a proxy for long-duration Treasuries, bottomed in mid-March.
"In other words, yields topped in Treasuries about three weeks ago," he said. "If commodities are meant to be inflationary, then why is it that the bond market is actually now starting to rally in price and drop in yield, because the bond market may be sensing that this is actually going to be negative."
As the bullwhip effect plays out, the price move in lumber could resolve itself through the slowdown of demand, which would suggest that we could be entering a risk-off period where higher volatility awaits.
"This relationship of lumber relative to gold like this can't sustain itself. If it can't sustain itself and it breaks down, my argument would be the probabilities are higher than people think that you could have an accident in the stock market," he said. "If lumber crashes, stocks might be next."
While it's hard to predict when corrections might occur until the current lumber-to-gold relationship breaks down, Gayed said the best hedge is to bet against the crowd when the crowd appears so one-sided as it is now.
That doesn't necessarily mean shorting stocks, but he points to Treasuries as a good place to seek safety. "Treasuries historically tend to be your best diversifier, meaning that we have a real risk-off period, yields drop more often than not, and that's your inverse correlation against equities," he said.
The other thing investors can do is dial down the overall aggressiveness of their portfolios. That means trimming down thematic plays such as tech stocks and overweighting defensive sectors like consumer staples, healthcare, and utilities, according to Gayed.
His advice also applies to crypto investors given the "insane leverage" in the space.
"If crypto goes through any kind of a correction or crash, it's also going to filter through to US equities," he said. "Anybody that's in crypto not because they're truly 'HODLing' it but because they're trying to play the trend, the more you trim your speculative winners in advance of a breakdown, the better."
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- Ex-Ark analyst James Wang breaks down his bull case for Ethereum as its token breaches an all-time high of $3,300 — and explains why it could eventually reach $40,000
