How the Lumber, Gold Relationship May Help Generate Superior Returns

When most investors think about how the market is doing, they’re usually looking at either the S&P 500 or the Nasdaq-100. That, in and of itself, is an incomplete view because it ignores asset classes, such as small caps, international stocks, junk bonds and Treasuries. It also doesn’t consider the intermarket relationships of these asset classes relative to one another.

This latter concept is incredibly important because it helps answer the question of what’s driving the market’s performance, not just whether “the market” is up or down. 

My investment approach is all about identifying conditions. It’s not about making “calls” or putting price targets on the S&P 500. I look at the relationship of asset classes to each other to help determine whether conditions favor investors taking a more cautious approach, positioning themselves as “risk off” or a more aggressive approach, positioning themselves as “risk on.”

Using these signals as a guide to develop risk rotation strategies can potentially help investors generate superior risk-adjusted returns, reduce drawdown risk and mitigate portfolio volatility. 

My preferred intermarket relationship is lumber to gold. In a world where investors pay attention to only about a dozen stocks, using lumber prices as a market indicator may seem odd, but history has demonstrated that the lumber/gold relationship used as a risk rotation trigger has some predictive power in positioning investors appropriately ahead of market events. 

Why Lumber and Gold? 

Lumber is considered a cyclical asset. At a high level, lumber is a play on housing. Housing is a play on the economy. If lumber prices are rising, it would make sense that the housing market is likely also doing well.

Since so many people have most of their wealth tied up in their house, it also makes sense that if housing is doing well, the economy is probably doing well too. If consumers see the value of their homes rising, they tend to feel wealthier, which encourages their willingness to spend. 

Gold is generally considered a defensive asset. When market conditions look unfavorable, investors flee to safe haven assets, such as Treasuries, the dollar or gold. These assets tend to rise in value if investor sentiment is relatively poor and they wish to protect their portfolio’s principal. 

I wrote a paper about this relationship that reached the following conclusion: 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. 

The benefits of this strategy are evident in the “Lumber/Gold Bond Strategy” that I detailed in the paper, which uses the S&P 500 as the “risk on” asset and a broad portfolio of U.S. Treasuries as the “risk off” asset. 

Over a period of more than 30 years, which include the 1987 Black Monday crash, the tech bubble, the financial crisis and the COVID-19 recession, the risk rotation strategy outperformed a buy-and-hold investment in the S&P 500 by nearly 300%. Plus, it did so in a much more risk-managed way. Volatility was significantly lower and the maximum drawdown experienced was just one-third that of the S&P 500. 

Investing shouldn’t be just about return maximization. It should also be about risk mitigation. Protecting against losses during market corrections can be just as, if not more, effective in generating superior risk-adjusted and absolute returns as taking more risk to hopefully achieve a little extra return. 

Using the lumber/gold ratio as a risk rotation signal can be one way to potentially accomplish that.