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Chart In Focus

Lumber Prices Call For Housing Stocks Rally

Chart In Focus
December 31, 2010

Longtime readers know that I like to get the answers ahead of time.  And one of the best answer-givers I have found is the price action in the lumber futures market. 

As far as commodities go, lumber is one of the smallest and most illiquid contracts traded in Chicago.  Total open interest at any given time is usually less than 10,000 contracts (compared to 3.4 million contracts recently for the eMini SP500).  So it seems unusual that we might be able to get useful economic or market related information from such a small market.  But lumber sits at the intersection of supply and demand not just for the raw materials and finished goods, but also for the capital needed to operate a mill and hold inventory. 

The lumber market also suffers from what economists call "inelasticity of supply".  Due to long lead times for procuring saw logs, and the need for significant infrastructure to process logs into finished lumber, it is hard for lumber mills to quickly ramp up greater production in response to a rise in prices. 

The really fun feature of watching lumber prices is the leading indication they give for what housing stocks will do a year later, as shown in this week's chart.  The plot of lumber futures prices is shifted forward in this chart by a year to reveal that lumber's dance steps get repeated to a large extent by the prices of housing related stocks. 

Lumber prices broke the long term downtrend line a year ago, and went on to rally in a big way up to a top in April 2010.  The Philadelphia Housing Sector Index (HGX) is just now breaking its own declining tops line, and appears to be starting a rally to echo the breakout move by lumber a year ago. 

If we zoom in closer on this relationship, we find out something interesting.  The HGX does a great job of echoing the timing of lumber's price movements, but the magnitudes of those movements are much less precise.  

Lumber and HGX Index

HGX has moved up off of its November lows right on schedule, but has not quite matched the magnitude of lumber's up move.  Coming up, the lumber price plot says that HGX should see a hesitation in the uptrend in early January, then resume its rise toward a top due in April 2011, the echo of lumber's April 2010 top. 

One caveat worth noting is that the magnitude of that early 2010 rally in lumber prices was exacerbated by the Feb. 27, 2010 earthquake in Chile, which disrupted that country's lumber production, and sent a shockwave through the world lumber market.  So the final up move to the April 2010 top was not solely a financial/liquidity driven rally in lumber prices, and thus we may not see a complete echo in the response by housing stocks. 

Tom McClellan
Editor, The McClellan Market Report

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