Materials Risk

Gold prices hit record levels this week. That much is old news now. What has escaped the front pages is that another commodity is also nearing record levels. That commodity is lumber.

Record price levels often represent a critical juncture. Either markets push through the resistance and power on, or it all becomes too much and gravity reasserts itself in a spectacular way.

Nevertheless, the relationship between the two commodities offers has offered important insights into the potential return on risk assets. It might pay to watch how each of the commodities plays out over the next couple months.

But first why is lumber important? When we are confident about the future of the economy we are more comfortable making big expensive decisions that are difficult or impossible to reverse. Think of buying a house or a second house even or starting a family!

House purchase activity is an important signal as to the health of the economy – both local and national. It’s not just the cost of the house but spending on all the other things involved with a house; renovation, construction and utilities etc. Together housing represents around one-sixth of the US economy.

A house is by far the largest single purchase that most people will ever make and so it’s an important signal of consumer confidence. Who wants to buy a house when they are worried about where their next pay cheque will come from?

Housing starts are a terrific leading indicator of the US economy. It can take several months for home builders to construct a new property and home builders are reluctant to break ground on new projects if they fear the economy may slump later in the year. Every recession in the US since 1960 has been preceded by decline in housing starts of on average around 25%.

Could there be an even better, even longer leading indicator? Well, the price of lumber is often seen as a leading indicator of the US housing market. Construction companies need to purchase materials to build new houses and the cost of the lumber is a key factor influencing the overall build cost.

If you start to see lumber prices decline sharply and for a prolonged period it typically means that a slowdown in housing starts is around twelve months away. However, as with all market based indicators supply as well as demand influences the price.

Many of you will know that copper and the cost of shipping dry freight are frequently cited as leading indicators of economic activity and demand for commodities. But another indicator that doesn’t get anywhere near as much coverage is the price of lumber in the US, and its relationship with the price of gold.

Research published by Michael Gayed and Charlie Bilello looked at the relationship between lumber and gold prices between 1986 and 2015. According to the research combining cyclical lumber with non-cyclical gold provides key information on when to “play offense” and when to “play defense” in an investment portfolio. Using weekly data available on lumber and gold prices going back to November 1986, the pair developed the following trading rule:

> If lumber is outperforming gold over the prior 13 weeks, take a more aggressive stance in the portfolio for the following week.
> If gold is outperforming lumber over the prior 13 weeks, take a more defensive stance in the portfolio for the following week.
> Re-evaluate weekly and make changes to the portfolio only when leadership between lumber and gold changes.

From late 2019 and through the first two months of 2020 the price of gold rose at a slightly faster rate than lumber prices. Equity and other markets including commodities fell sharply thereafter as the scale of the impact from covid-19 became clearer. The past two months have seen the roles dramatically reversed with lumber prices up 60% compared with an 11% rise for gold.

Chart: gold versus lumber prices

Gayed and Bilello’s model implies that this means investors should be more aggressive with their portfolio’s, i.e. greater weighting to equities and more small-cap socks for example.

Lumber like many commodity markets has not gone unscathed from the covid-19 pandemic. Many lumber mills were forced to close, or at least severely limit their output during April and May due to social distancing restrictions.

That being said the lumber-gold ratio has been an important bellwether for risk assets in the past despite historical supply disruptions. As both commodities hover near record highs the next couple months are likely to offer an important signal as to the future direction for equity markets.

Related article: The Baltic Dry Index is a lousy predictor of commodity prices

Related article: The predictive power of the copper-gold ratio

Much of what is observed in economic and financial markets is explained away in rational economic terms: improvement in economic data led to a rise in the stock-market, gold prices rise on declining bond yields or something similarly mundane. Yet the recurrent bouts of volatility across all asset markets suggest that something deeper is going on, something much more powerful than the observed fundamentals suggest.

To understand what might be going on we turn to the world of ants.

In the opening passages of the book Butterfly Economics, Paul Omerod, describes a series of experiments carried out by entomologists in the mid-1980’s. The question the scientists were trying to answer was how would an ant colony divide itself between two identical sources of food – each source exactly the same distance away from the colony, and each constantly replenished?

On the face of it nothing to do with volatile movements in asset prices.

Rather than choosing from the two sources at random, ants typically went back to the same source again and again, and once back at the colony they would signal to other ants the direction of their food source. Positive feedback dominated and once a large majority of ants visited one site it tended to remain stable for some time. Every so often though ants suddenly shifted and moved almost on mass to the other food source.

The economist Alan Kirman modeled the ants behaviour. Essentially each ant has three possibilities upon leaving the colony: it can visit the source it previously visited, it may be persuaded by a returning ant to visit the other source, or it can decide itself that it will try the other food source.

These three possibilities also guide participants in financial markets. The precise shape of the distribution between ants at one or the other food source, or financial market participants between being bullish or bearish depends upon the persuasiveness with which ants (investors/banks) can convert others, and on the propensity of individuals to change their own minds.

With that framework in mind consider whats happening in the gold market at the moment.

According to Longview Economics (h/t John Authers) there is a risk that the gold market shoots higher as bullion banks (traditionally short the gold market) suddenly have to make good on the promises they have made to investors betting on higher gold prices through futures. Longview estimates that the short position is around $39 billion, the highest since records began in 2006.

If gold prices don’t decline materially and investors opt to take physical delivery of the gold (rather than rolling over the contracts), then the banks may be forced to pay almost any price they can to get hold of the metal:

Bank runs occur when lots of depositors demand their money back at the same time. The bank, of course, doesn’t keep all their money in the bank. Deposits are lent out as loans (and so on). As such banks suffer short squeezes of liquidity if too many depositors ask for their money at the same time (unless, and until, the central bank steps in with newly created liquidity).  

Just like in a bank run, therefore, if too many gold future holders decide to take delivery of physical gold at the same time (rather than simply rolling their contracts), then it’s likely the swap dealers won’t be able to satisfy all those demands (i.e. the physical gold isn’t there/available).

It’s with that backdrop that we wonder if the ‘other reportables’ investors/speculators are deliberately, or just coincidentally, trying to create that situation (akin to how hedge funds/other investors exploited the lack of storage capacity at Cushing, helping to push the oil futures contract into negative territory in April).

If so, then this will be one of those ‘rare’ occasions when the message of the positioning, sentiment and other models is wrong – and markets don’t immediately mean revert but enter into one of their occasional parabolic price moves.

The banks, as with the ants may decide by themselves or be persuaded by other participants to switch dramatically from being short the gold market to being long. The message from the world of ants is that once a critical mass of individuals switch from one side to the other, the market can switch on a dime, and in this case driving the gold market even higher.

Whether it occurs or not, the analogy of the ants demonstrates why its important to understand the behaviour and incentives of individual market participants.

Related article: Positioning analysis in commodity markets: An interview with Mark Keenan

2020 has been unprecedented. Just over half distance and we’ve faced the prospect of World War III, a global health crisis, the worst recession for several decades, race riots and a plagues of locusts. I’m sure the second half will be fine. A divisive US Presidential election and structural problems with China’s Three Gorges Dam? Nothing to see here.

The events and their confluence have been unprecedented, yet it is the coronavirus that is understandably contributing most to individual perceptions of uncertainty. As the Bank of England describe in a recent paper, there is uncertainty about almost every aspect of the COVID-19 crisis:

On the epidemiological side these include the infectiousness and lethality of the virus; the time needed to develop and deploy vaccines; whether a second wave of the pandemic will emerge; the duration and effectiveness of social distancing. On the economic side, these include the near-term economic impact of the pandemic and policy responses; the speed of economic recovery as the pandemic recedes; whether temporary government interventions will become permanent; the extent to which pandemic-induced shifts in consumer spending patterns, business travel, and working from home will persist; and the impact on business formation, and research and development.

The Bank of England used two sentiment based measures of uncertainty to show how the current crisis compares with economic and political events of the past two decades. Newspaper based measures reflect the real time uncertainty perceived and expressed by journalists. Meanwhile, Twitter based measures reflect the same real-time fears among everyone with a Twitter account. Both measures reflect articles and tweets that contain the terms “economic” and “uncertainty” and variants of them. Both measures align reasonably well and clearly show a spike in perceptions of uncertainty to record levels in early 2020.

The question is really whether uncertainty is really that unprecedented. After all the future is always uncertain. It has always been that way. It always will. Could it be our perceptions and how they are formed that is the real driver behind the apparent surge in uncertainty?

As I describe in my latest book, until relatively recently the media was something that was done by ‘others’ and broadcast to you and I. That changed with the advent of social media. Now we can all wield some power. But in doing so it has subverted our perception of the world and exaggerated each individual’s perspective as the one true reality. When the media has too much influence over the reality it was designed to mimic, the flow of information becomes increasingly less efficient. In this world, expectations, perception and opinion are the currency of influence.

The narrative of COVID related uncertainty is continually propagated in a strong feedback loop. The media publish stories highlighting the uncertainty. Twitter and other social media users spin their perceptions out to their followers. The divisive nature of social media makes it worse as groups flock to whichever side of the debate they feel most closely fits their perception of reality.

Not knowing what lies ahead can freeze you in your tracks. Here’s how to break the paralysis to weigh your financial choices and make a plan. https://t.co/UqDJpO6O07

— The Wall Street Journal (@WSJ) July 17, 2020

Uncertainty is all about low levels of confidence. In the same way that psychology indicates that we dislike losses twice as much as an equivalent gain, we abhor uncertainty more than we crave certainty. In the words of Yuval Noah Harari we are “full of fears and anxieties over our position, which makes us doubly cruel and dangerous.” According to Peter Atwater, uncertainty can seem precarious due to two key elements:

The first is truthfulness. When things are uncertain, we have difficulty distinguishing fact from fiction. We don’t know who or what can be believed or trusted. That we are now awash in conspiracy theories and “fake news” should come as no surprise then. Truthfulness is binary; and the more that is uncertain the more that IS uncertain. Like so many things confidence-related, there is reflexivity to certainty that leads to both virtuous and vicious cycles.

Which brings me to the second element of certainty: predictability. When things are certain, there is an order that we believe can be extrapolated into the future. Not surprisingly, there is a high correlation between confidence and norms, rituals, habits, routines, laws, rules, and regulations.  Whether codified by law or through muscle memory, we love to know that what is will be the same ahead. 

On the other hand, when things are uncertain, we perceive a dangerous randomness in which anything can and will happen. Planning amid uncertainty seems foolish.

Preying on the stressed and fearful is big business. It’s perpetuated by and in turn driven by the media cycle. It drives demand for everything from insurance, burglar alarms, even gold. Remember though that perceptions of uncertainty are built on nothing more than confidence. As the uncertainty index chart demonstrates, ‘animal spirits’ can rapidly turn from depression to euphoria, and vice versa. For the investor this means being attuned to the media news cycle, not being drowned by it, but just observing it.

Related article: The narrative machine

Related article: Take back your thinking

Related article: Information overload