Where can lumber markets go from here?

After hitting their lowest level in nearly 25 years (adjusted for inflation) late in the first quarter and early in the second quarter of 2007, lumber prices rallied into the third quarter. However, this rally could almost be described as trivial: at a peak of $307, the Crow’s Framing Lumber Composite Index was just 15 percent above its first- and second-quarter lows and a full 20 percent below the 2006 peak. Moreover, lumber markets have given back much of this gain in recent weeks. Since peaking around the Fourth of July, the Crow’s Composite Index has fallen nearly 10 percent. Where do lumber markets go from here?

Lumber consumption is highly correlated with construction activity, as the two main end-use markets for lumber are new home construction and repair and remodeling.

As anyone following recent developments in mortgage markets can attest, the outlook for housing is at best stormy. The bad news isn’t all on the financing side either. Inventories of unsold new homes in May, expressed as months of sales at the current sales pace, were at 7.8 months, up 22 percent over a year ago. For existing homes, an 8.8 months inventory in June represents a huge 28 percent year-over-year increase. This is worrisome for new-home builders, as a large unsold inventory of existing homes could hold up those existing-home sellers trying to upgrade by buying and moving into a new home.

While there are few reasons to hold out hope that recovery in U.S. housing markets will occur any time soon, a further substantial erosion in starts is also unlikely. Solid employment and income growth, falling existing-home prices and flat new home prices have all improved housing affordability. Moreover, U.S. housing starts seem to have found a market bottom.

The second largest end-use market for lumber, repair and remodeling remained stronger than new housing construction in 2006 (data on repair and remodeling expenditures lags that of housing starts). This is in part because of the tremendous amount of cash pulled out of home equity in recent years: cash-out exceeded $300 billion in 2006, 16 percent above 2005 levels and many times the $30 billion average of the 1990s. Some of this influx of cash to homeowners was spent on their homes for re