recovery is far from being assured.
The shocking thing to consider is how many trillions of dollars the Federal Reserve has pumped into the economy, and yet all we have to show for it is this very weak economic recovery. To me, this means that the underlying strength of the economic recovery without the Federal Reserve’s support would be much weaker.
While on the surface it appears that the economic recovery is taking place, I believe that without the support of the Federal Reserve, we would see a substantial drop in economic activity. Much like a balloon filled with air, the economic recovery needs a constant injection of stimulus otherwise it would deflate completely. That’s not what I would call a strong foundation to build upon.
There appear to be new signs of the fragility of the current economic recovery. One of the strongest sectors that have benefited from the Federal Reserve’s monetary policy is housing. Naturally, lower interest rates increase affordability for buyers, all else being equal.
There is a lot of news about strong year-over-year home price gains and activity among homebuilders in construction. Yet lumber prices are telling a contrary story.
Chart courtesy of www.StockCharts.com
The chart above shows lumber prices against the S&P 500. Lumber is one of the more volatile commodities, yet it has shown over the past few years that it does have a correlation with the S&P 500.
Naturally, when housing improves, the result is more construction, and increased levels of construction also mean increased demand for lumber. This has been the case for the past couple of years; however, lumber prices have recently dropped substantially—while the market remains elevated.
That dissonance between lumber prices and the market level could simply be a short-term aberration during which a huge level of lumber supply hit the market and pushed down prices over the short-term. However, it might also be indicating that the economic recovery is far from certain. While the Federal Reserve has done what it can in terms of lowering interest rates, there are still massive structural reforms that are preventing true long-term growth.
I think the S&P 500 is pricing in a lot of good news, essentially assuming a full economic recovery is a certainty. Someone allocating capital at the current level would have to make a lot of assumptions, the most important is that not only will the economic recovery continue, but that the market can withstand a situation in which the Federal Reserve begins to reduce monetary stimulus.
At this point, I don’t think there is much upside left in the stock market, and I believe there is a far greater possibility of a significant sell-off. The underlying economic recovery cannot stand on its own feet without the support of the Federal Reserve. Increasingly, members of the Federal Reserve have voiced their opinion that the aggressive monetary stimulus will begin being reduced shortly. I think that will be a strong catalyst for a significant sell-off.
Can lumber prices predict the future? Of course not; however, they might be the canary in the coal mine giving us an indication that the foundation beneath the current economic recovery is not very solid.
This article is brought to you courtesy of Sasha Cekerevac from Investment Contrarians.
Related: Guggenheim Timber ETF (NYSEARCA:CUT), iShares S&P Global Timber & Forestry Index Fund (NASDAQ:WOOD).