Nearly every major correction and crash going back to 1987 was preceded by weakness in Lumber. Despite a strong comeback off the low, Lumber is turning lower again [and that does not bode well for small cap equities as a result. Why is that? Read on!].

Factually, the price of Lumber matters because the average home has about 14,000 board feet of lumber, making wood prices a key tell on the strength of future housing.

• If Lumber is weak, it means construction is weak.
• If construction is weak, it means housing is likely to be weak.
• If housing is weak, credit creation and wealth for most Americans whose wealth is their home declines.
• Historically, when Lumber, relative to Gold, is weak on a rolling 13 week basis [as illustrated in the chart below], it suggests an environment to come that is more volatile.

• if Lumber is weak, then small-cap stocks should be weak [because]?
  • small caps are traditionally higher beta and higher volatility equities and tend to perform better during expansionary periods,
  • small cap revenues are also more domestically focused than multinational large caps and by extension tend to be more sensitive to cyclical swings in housing and the U.S. economy so,
  • when Lumber is outperforming, then, we would expect on average to see small cap leadership [and, conversely,]
• • when Lumber is weak, then small-cap stocks should be weak [and, as you can clearly see in the chart below, they are!].

Small-caps are no where near their prior highs. Weakness against the S&P 500 (SPY) is very serious here.

By rotating into the Russell 2000 Index when Lumber is outperforming Gold, an investor would have picked up an additional 2.7% per year of annualized returns over the S&P 500 with improved risk-adjusted metrics as well. Volatility is higher for this strategy than the S&P 500 (17.7% vs. 16.7%) but given the alpha of 2.8% per year you are being compensated for this higher volatility.

I'm still fairly optimistic as the weight of the evidence still suggests we are due for a reflation bounce, but I don't like the action I'm seeing in Lumber and small-caps, especially given expected Fed cuts coming. If you're bullish, I think these are the charts to watch actively. They may be the canaries in the coal mine for a correction ahead.

Editor's Note: The above excerpts from the original article by Michael A. Gayed, CFA have been edited ([ ]) and abridged (?) for the sake of clarity and brevity. The author's views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Gayed is receiving compensation from Seeking Alpha for pageviews of his original article as posted there so please refer to it for the unedited version. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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