Lumber – Worth It’s Weight In Gold: Offense And Defense In Active Portfolio Management by SSRN
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Pension Partners, LLC
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Pension Partners, LLC
May 8, 2015
2015 NAAIM Wagner Award Winner
Prior academic research focuses on commodities in isolation as leading economic indicators, ignoring the message price behavior may have on other asset classes. We find that the relative movement of Lumber to Gold provides important information on economic growth and inflation expectations, which gradually diffuses with a lag to stock and bond markets. Lumber’s sensitivity to housing, a key source of domestic economic growth in the U.S., makes it a unique commodity as it pertains to macro fundamentals and risk-seeking behavior. On the opposite end of the spectrum is Gold, which is distinctive in that it historically exhibits safe-haven properties during periods of heightened volatility and stock market stress. We find that the relationship between Lumber and Gold helps to answer the critical question of when to “play defense” and when to “play offense” within the context of active portfolio management. In this paper, we show that a strategy using the signaling power of Lumber and Gold results in stronger absolute and risk-adjusted returns than a passive buy-and-hold index. This outperformance stems from being more aggressive in a portfolio during periods when Lumber is leading Gold and being more defensive during periods when Gold is leading Lumber. The results are robust to various time frames and across multiple economic and financial market cycles.
Lumber – Worth It’s Weight In Gold: Offense And Defense In Active Portfolio Management – Introduction
Active portfolio management rests on the belief that it is possible to outperform the “market,” either on an absolute or risk-adjusted basis, by executing a strategy that in some way deviates from a passive buy-and-hold portfolio. The Efficient Market Hypothesis (EMH) states that such outperformance through active management is largely impossible because prices incorporate and reflect all relevant information. However, there are a number of market studies that have disproven the null hypothesis of this theory. Two of the strongest and most well-known anomalies are the “value” effect and the “momentum” effect.
Such studies tend to be asset-class specific, documenting potential outperformance by looking for unique factors specific to the asset class being analyzed. In this paper, we take a different approach and look across asset classes to determine if there is information contained in one area of the investable landscape (commodities) that can be applied to another (equities). Specifically, we show how Lumber and Gold contain important information on macro fundamentals and how their relative movement/momentum impacts risk-seeking and risk-averse behavior in stocks.
We propose that the factors which impact Lumber and Gold spillover to equity investors and traders who, with a lag, respond to that information in a consistent and repeatable way over time. As Lumber outperforms Gold, equities tend to exhibit an upward bias and have lower volatility. These are conditions that are conducive towards maintaining higher exposure to risk assets. As Gold outperforms Lumber, the opposite tends to be true, whereby the inclusion of lower beta assets in a portfolio increases overall return and lowers volatility at the time it is needed most. The relationship between Lumber and Gold helps to answer the most critical question for active asset managers: when to take more risk (“play offense”) and when to take less risk (“play defense”) in an investment portfolio – before it’s too late.
Lumber as a Cyclical Leading Indicator
Lumber futures receive little attention as compared to industrial metals such as Copper which are often viewed as leading indicators of economic growth. Investors may be underestimating Lumber’s importance, though, as housing and construction tend to be major components of the business cycle. Housing greatly “influences the level of consumer spending” and is the “primary store of wealth for most Americans.”
It should come as no surprise, then, that housing permits are one of the key leading economic indicators in the U.S., ranking ahead of the S&P 500 in their ability to signal a turn in the economy. Leamer (2007) showed that housing is “the most important sector in our economic recessions” and residential investment is often “the first item to soften and the first to turn back up” before and after recessions. We can readily observe these leading characteristics in Chart 1.
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