Gold is the hottest commodity of 2020, right? Kind of. Going by increases in the year to date, it is in fact not the top performer. The precious metal has certainly become more than a hedge on equities or the US dollar this year as more and more investors have dived in, but its 20 per cent rise to around $2,000 (£1,493) an ounce (oz) can’t get near lumber, which has climbed more than 130 per cent in the past six months, to over $800 per thousand board feet (mbf). Even giving gold another six months, to when the bull market started in May 2019, it is up only 52 per cent.
There is a specific investment strategy built around this situation. The 2015 research paper Lumber: Worth Its Weight in Gold Offense and Defense in Active Portfolio Management, by Michael A Gayed, lays out a plan based on the relative performance of gold and lumber, specifically looking at US markets. The underlying idea is that high lumber demand from homebuilders indicates general economic strength, which Mr Gayed says is correlated with better returns from equities.
It is true that the recent strength of both lumber and gold means the correlations established in 2015 do not look as strong today, but over the long term Mr Gayed presents a compelling reason to track lumber.
Upward bias
“As lumber outperforms gold, equities tend to exhibit an upward bias and have lower volatility,” the paper said. And it is true that while the volatility index has climbed up recently, it is around a third of its peak in March.
There is also no question that US equities, led by tech stocks, have trended higher this year. In the past six months – which included the March crash as Covid-19 cases skyrocketed and the world went into lockdown – the Nasdaq 100 is up 38 per cent, S&P 500 up 14 per cent and lumber is at record highs.
Lumber’s rise is not just in the US. The UK’s Timber Trade Federation warned of limited stocks locally due to housebuilding and DIY demand. “Anyone who has tried to buy studding or joists recently will know that the current crisis and the strength of the DIY and independent merchant sectors have reduced UK softwood stocks probably lower than they have ever been,” said Nick Boulton, head of the federation’s technical and trade unit. He said this was also the case in Europe.
From a trading point of view, lumber futures have become hot property. Saxo Bank’s head of commodity strategy, Ole Hansen, said last month that the September futures had hit double the average of the past 10 years. The ramp-up is the product of DIY consumer demand during a period when inventories were already low, partly due to tariffs on Canadian lumber coming into the US, Mr Hansen said.
But while recent trends – relative outperformance of lumber versus gold and a sharp increase in equity markets – reflects the strategy set out by Mr Gayed in 2015, the picture isn't as clear cut as it might seem. Indeed, equity gains are fairly limited when tech stocks are ignored.
Small gains
What's more, Mr Gayed’s 2015 plan said small-caps were the way to go when lumber was outperforming gold. Looking at the current US market, where a few colossi are dominating, the small-cap space has not done as well. Helpfully, Mr Gayed has recently published a blog looking at why his plan is not working out. “[Small-caps are doing] the opposite of what is expected,” he said on 31 August. “They are underperforming large-caps this year to the tune of about 14 per cent.” As of the end of August, he said 60 per cent of S&P 500 constituents were down since the February peak of the index, pointing to the concentrated nature of the rally as a sign it was not going to last, on top of the recession. So either small-caps are about to shoot up, following lumber, or the recession will bite.
Taking the pessimistic view – also based on a treasury bond ETF coming off 5 per cent in the past month – it might be time to look at the defensive strategy.
In the research paper, Mr Gayed calculated an annual return of 11.2 per cent by buying into bonds when gold outpaced lumber between 1986 and January 2015, compared with an S&P 500 annual return of 10.1 per cent. The major difference was the peaks and troughs – investors might lower their blood pressure by using the lumber indicator, as drawdown was 14.5 per cent between 1986 and 2015 compared with 55 per cent for the equity-only portfolio. Using the same time period, the small-cap lumber-outperforming-gold strategy generated an annual return of 12.8 per cent.
