A Sector Primed to Pop in 2014

11/12/2013 7:00 am EST


Tom McClellan

Editor, The McClellan Market Report

Housing industry stocks, as a group, appear poised to start a strong pop up into early 2014; that’s the message from looking at the chart plot of lumber prices, says By Tom McClellan of The McClellan Market Report.

It was back in 2008 that I discovered that lumber prices give a good model one year ahead of time for what housing stocks should do. I figured that there ought to be some relationship between lumber and housing, and when I put the two series together on a chart it was obvious there was some relationship as expected. But it did not look quite right. Shifting lumber prices forward on the chart was the key to unlocking the real relationship. The same dance steps that appear in lumber’s price movements tend to be traced out about a year later in the prices of housing sector stocks.

Click to Enlarge

The movements of the HGX Index do not replicate exactly what lumber prices did before. There is some understandable variation. That’s why I use the term “dance steps,” because two dancers could each dance the charleston, or the electric slide, and have it be recognizable as such, even if they don’t dance exactly the same way.

This principle of using the movements of one data series to forecast the subsequent movements of another is a principle I like to refer to as “liquidity waves.” I liken it to a wave at the beach, which passes under the end of a pier, and then later hits the shoreline. It is still the same wave, but it appears at different times in different places.

As 2012 was ending, lumber futures prices had been trending higher but then surged upward much faster toward a top that came in March 2013. It is the echo of that exact surge in lumber prices, which ought to be starting very soon for housing related stocks, headed toward a top due around March 2014. Afterward, lumber foretells a big summer swoon in 2014 for the housing sector, before a recovery toward the end of next year.

The news stories in the financial media lately would seem to contradict an expectation of anything positive for the housing sector. Household formations are at a low level, as the millennial (echo-boom) generation are still living with mom and dad. The ECB says that the economy is going to remain weak. The Fed is still too worried to start tapering. All of that should mean a weak economy and thus a weak housing sector, if it plays out that way.

But lumber’s story is a more positive one, so maybe the lumber market knows something that the economists do not. Lumber sits at the intersection of a wide variety of supply and demand factors. There is the cost of the raw timber (uncut logs), plus the cost of fuel and manpower needed to get it to the mill. Then the mill has to add labor and electricity to turn that timber into lumber, and factor in some additional costs for the real estate which all of the above will occupy at various stages of the process, and finally the cost of capital to finance it all. Demand inputs vary with the housing market, as well as the other uses for commodity finished wood products.

Why the lag time is one year for movements in lumber to be echoed in housing stocks is something I cannot answer. But I have seen enough evidence to satisfy myself that it is so, even if I cannot explain it.

There was a notable misstep by HGX in the center of the chart, when it did not echo the magnitude of a move we saw in lumber prices. And in that anomaly, there is information about how this relationship works. Lumber prices had spiked way up in early 2010 because a big earthquake in Chile shut down sawmill operations there, and sent lumber users scrambling in a classic supply squeeze. Then lumber prices went crashing back down as the lumber market normalized.

But housing stocks did not echo that extreme price spike much at all, although the timing of its up and down moves was generally in line. That tells me that lumber’s price movements do not “cause” the similar moves a year later in housing stocks. Instead, I would say that there is some other causative factor affecting both markets, and its effects just show up first in the lumber market.

People tell me all the time that “correlation does not mean causation” whenever I show one of these liquidity wave relationships. But I don’t care about “causation”, but rather “indication”. And when one can get good answers a year ahead of time, that is a pretty nice thing, even if they are not perfect answers.

By Tom McClellan, Editor, The McClellan Market Report

Related Articles on STOCKS