With the US stock
markets very overextended technically, my recent research has
focused on this development?s implications. Several weeks ago I
outlined the extremely
overbought
conditions in the flagship S&P 500 stock index (SPX). Last week
I explored how the overdue SPX pullback is even likely to
spill over into
the precious-metals stocks, dragging them down.
After reading that
essay, many investors wrote in wondering how general commodities
stocks would fare in a significant SPX pullback. The short answer
is not very well. Commodities-stock investors and
speculators alike have to realize that any meaningful SPX weakness
will have a serious impact on commodities stocks, even if
commodities prices themselves happen to be rising at the
time.
Although
commodities producers? profits and hence stock prices ultimately
follow commodities prices over the long term, over the short term
sentiment is usually a far more important driver. If traders are
excited, they?ll eagerly buy commodities stocks. But when they get
scared, they are quick to sell these same stocks. And nothing
breeds fear and economic worries as rapidly as sharp retreats in the
stock markets.
The precedent on
this psychological spillover effect is very clear, even in the
powerful cyclical
bull market since the March 2009 post-panic lows. I?ve written
about this general-stock influence over near-term commodities-stock
fortunes many times in our subscription newsletters. With our
subscribers? capital already prepared, it?s probably about time to
summarize this research in an essay.
In order to
understand how commodities stocks are likely to perform in the next
meaningful SPX pullback, we need to look at how they performed in
past SPX pullbacks. Since March?s despair-laden lows, the US stock
markets have had 8 pullbacks. But only one has been ?meaningful? so
far, big enough and long enough to really rebalance sentiment by
injecting fear to bleed away complacency and greed.
To gain insights
into how commodities stocks performed in these past pullbacks, we
have to first find some way to measure them. And unfortunately this
isn?t easy. I?ve been relentlessly studying and actively trading
commodities stocks since this bull began
in 2001. In
all the years since, I?ve yet to see an excellent commodities-stock
index. Plenty have been introduced, but all are seriously flawed.
They are often
dominated by eccentric component stocks that don?t actually produce
commodities, comprised of incomplete component lists excluding some
of the best and most important producers, and/or illogically
weighted internally. Nevertheless, these flawed indexes are still
the best way to measure commodities stocks? progress. So we must
choose the least-poor index from this admittedly poor field.
These days my
choice is XLB. The 500 elite stocks of the S&P 500 are divided into
9 sectors. Each of these sectors is independently tradable via a
popular family of ETFs known as the Select Sector SPDRs
(?spiders?). XLB represents the materials stocks of the SPX.
Although unfortunately heavy with chemical producers, the XLB
Materials SPDR also includes big weightings in Freeport McMoRan
Copper & Gold, Newmont Mining, and Alcoa.
So while XLB is
far from an ideal commodities-stock index, it does have enough big
producers to act as a reasonable proxy for commodities stocks in
general. But despite containing some giant commodities companies,
all the stocks in the XLB still account for merely 3.5% of the SPX?s
total market capitalization! This highlights just how contrarian
commodities stocks remain today, which is very bullish. Also be
aware that the SPX energy stocks are a different case included in a
separate ETF, the XLE Energy SPDR.
By seeing how XLB
has behaved in the 8 SPX pullbacks since March, traders can get an
excellent idea of how commodities stocks are likely to behave in the
next SPX pullback. This first chart overlays the XLB on top of the
SPX, and they track nearly perfectly. For each SPX pullback, three
percentages are noted. The red one is the SPX?s pullback loss and
the blue one is the XLB?s loss over this exact same SPX-pullback
span. Finally the yellow one documents the CCI?s performance over
these SPX-pullback spans.
The
Continuous
Commodity Index is the benchmark measure of general
commodities price action. Theoretically commodities stocks should
follow commodities prices over the long term, since the latter
dictate the former?s ultimate profits. But as this chart reveals,
over the short term a weak SPX overwhelms commodities-stock
psychology and easily dominates whatever is happening in
commodities.
Comparing the XLB
to the SPX is really visually-striking. These charts are
essentially interchangeable, one could easily be passed off as the
other. And this relationship is stunning mathematically as well.
The correlation r-square between the XLB and the SPX since the
latter?s March low is a staggering 97.2%! Statistically, 97% of the
XLB?s daily trading action was directly explainable by the SPX?s
own.
Contrast this with
the CCI, with which the XLB had a far weaker 80.9% r-square over
this same span. There is simply no arguing the fact that the
general stock markets are a far greater influence over tactical
commodities-stock price action than the commodities prices
themselves. Thus investors and speculators who first consider the
state of the SPX before trading commodities stocks will have much
greater success.
These specific SPX
pullbacks rendered here were explained a few weeks ago in
another essay,
so we don?t need to rehash that analysis today. This time our focus
is on how commodities stocks, as represented by the XLB, did during
these SPX-pullback spans. And in addition to comparing the XLB?s
loss to the SPX?s, the parallel performance of the CCI offers a kind
of control to see how outsized the XLB?s reaction to the SPX proved.
During the first
pullback in late March, the XLB?s 5.6% loss paced the SPX?s 5.4%.
Nevertheless, with the CCI falling by a more moderate 3.1% the
commodities stocks still appeared unduly influenced by the SPX
weakness. This behavior continued in the second pullback in
mid-April, with the XLB?s 4.6% loss being much closer to the SPX?s
4.3% than the CCI?s 2.5%.
In the third
pullback in May, this SPX influence moderated a bit. While the
headline stock markets lost 5.0%, the XLB showed some relative
strength with just a 3.6% loss of its own. Interestingly the CCI
only declined 2.2% over this span, so better commodities-price
performance helped favorably influence commodities-stock psychology
at the time.
The SPX?s fourth
pullback in June and July has been its only significant and
meaningful one so far in this cyclical-bull upleg. The SPX lost
7.1% over 19 trading days, more than enough to stoke the fires of
fear and burn away some of the excessive complacency and greed. It
was actually during this pullback that I first started considering
the XLB?s behavior, as commodities stocks really didn?t fare well.
This ETF lost a brutal 13.2% over this span, leveraging the SPX?s
retreat by 1.9x.
It is certainly
true that commodities prices too were weak over this summer span,
also negatively influenced by the SPX?s far-reaching sentiment
splash damage. The CCI fell 7.0% to the SPX?s 7.1%. But still, the
XLB?s decline was pretty excessive considering commodities prices
remained at levels which were very profitable for the best
producers. With commodities stocks nearly doubling the SPX?s
losses, today?s traders must remain wary of the next meaningful
SPX pullback?s impact on commodities stocks.
During the fifth
pullback in mid-August, the CCI?s 4.5% loss actually outpaced the
SPX?s 3.3% for the only time in this entire upleg. With both
general stocks and commodities weak, the commodities stocks didn?t
stand a chance and plunged 6.2% over just 2 trading days.
The SPX?s sixth
pullback ending in early September was also revealing. This elite
stock index lost 3.5%, but over this same span commodities were
actually surprisingly strong with the CCI gaining 0.7%. If
commodities prices were a bigger influence on tactical
commodities-stock action than the SPX, here is where we would have
seen it. Yet the XLB still sunk 2.7%, somewhat splitting the
difference between the SPX and CCI but mostly ignoring the
commodities gains.
The seventh
pullback running into early October probably would have become the
first meaningful one since summer if the impressively-bullish Q3
earnings results hadn?t short-circuited it. The SPX fell 4.3% over
8 trading days where the CCI was only off 1.7%. Yet the XLB really
took this poorly, falling 7.6% which leveraged the SPX?s decline by
1.8x. Again we saw this 2-to-1 downside metric approached.
Highlighting just
how absurdly overbought the SPX had become, its eighth pullback
started right in the midst of incredibly bullish Q3 earnings results
from many elite market-darling stocks. The SPX gradually slid down
5.6% in 9 trading days, but once again commodities remained
relatively resilient as evidenced by the CCI?s mild 2.8% decline.
Yet the XLB still plunged 9.8%, 1.8x downside leverage.
See the precedent
here? When the SPX is weak yet the CCI still rallies, commodities
stocks sell off. When the SPX is weak but the CCI is relatively
resilient, commodities stocks sell off. And when both the SPX and
CCI are weak, commodities stocks really sell off.
General-stock-market weakness has been weighing on commodities
stocks this year no matter what commodities prices happened to be
doing. These SPX pullbacks are the biggest short-term risks that
commodities-stock traders face.
And this risk is
really heightened today considering it has been so long since the
SPX last saw a meaningful pullback. The commodities stocks? worst
performance relative to the SPX happened during that larger
June/July pullback. Back then the SPX fell far enough, for long
enough, to spawn serious and universal doubts about the prospects
for the stock markets and economy. And since commodities prices are
heavily dependent on economic activity, these fears weighed
disproportionately on their producers.
The SPX?s next
pullback is likely to be meaningful as well, big enough and long
enough to finally burn away some of today?s excessive complacency
and greed. In order to see sentiment rebalanced, which is the sole
mission of any pullback or correction, some real fear will have to
arise. And of course this will manifest itself in economic worries,
almost certainly leading to heavy selling in the commodities stocks.
This exceedingly
important relationship between the SPX and commodities stocks can be
considered from other perspectives too. This next chart looks at
the ratio between the XLB and the SPX. This line (multiplied by 100
to eliminate the tiny decimals) deftly shows when commodities stocks
have been outperforming the SPX and vice versa. For comparison,
this blue XLB/SPX Ratio is rendered over the CCI in red. This chart
offers many interesting insights, including some disturbing ones.
From March to
early May the XLB/SPX Ratio (XSR) rocketed higher. Commodities
stocks were gaining ground much faster than the general stock
markets, which was no mean feat since general stocks were soaring
too. But by early May, these outsized commodities-stock gains had
run out of steam as the XSR x100 approached 3.0. From here the
SPX?s third pullback started an XSR trading range that has largely
held to this day.
For the next 6
weeks or so this ratio oscillated within this nascent uptrend.
Commodities stocks were still rallying faster than the general
stocks on balance, but only gradually. But when the SPX?s last
meaningful pullback hit hard in June, the XSR fell off a cliff and
shattered its support. You can see this fast and furious
commodities-stock plunge driven by the fourth pullback above. It
really was stunning just how fast and far commodities stocks plunged
compared to the general stock markets.
By the time the
dust settled in the SPX in early July, the XSR was back down to
mid-March levels! Over nearly 4 months, commodities stocks had not
gained any ground at all relative to the SPX. This is really
sobering to me, and it ought to be to you too. The degree of XLB
underperformance during the last meaningful SPX pullback was
immense. Commodities stocks are likely to exhibit similar outsized
selling pressure in the next meaningful one as well, which is way
overdue.
But after the
carnage of the fourth pullback, buyers returned in droves and the
XSR rapidly soared back up through support to revisit resistance.
Once again all was well in the world of commodities stocks. When
the stock markets are rising, these stocks really thrive. And they
should, because they suffered such epic losses in 2008?s stock panic
that most of them remain nowhere close to rebounding far enough yet
to reflect today?s prevailing commodities prices.
In mid-September,
the XLB/SPX Ratio again fell sharply as the SPX?s seventh pullback
heavily pressured commodities-stock sentiment. But then some
curious things started to happen. I mentioned above that this
September pullback was shaping up to be the first meaningful SPX
pullback since summer until the Q3 earnings season short-circuited
it. But despite elite commodities stocks having big Q3 beats too
(bigger than the elite tech stocks in some cases), the XLB did
not recover with the SPX.
While the SPX
clawed its way to marginal new highs in mid-October, the XLB
lagged. This drove the ratio to a much lower high in October than
September. Disturbingly, this episode was the first time since May
that a new SPX high didn?t translate into the XSR climbing back up
to resistance. At the time I warned our
Zeal Speculator
subscribers that the unenthusiastic commodities-stock participation
called the whole SPX rally?s legitimacy into question. Something
didn?t smell right.
And this
disconnect looked even worse considering the CCI action.
Commodities prices were soaring in early October right along
with the SPX. The never-ending stream of high-profile corporate
profits and sales exceeding expectations in Q3 sparked much economic
hope. Futures traders rushed to buy commodities anticipating higher
demand, but commodities-stock buying was still tepid at best.
When both
the stock markets and commodities prices are rallying sharply
yet the commodities stocks refuse to respond as usual, it is a big
warning sign. The XSR?s divergence from the CCI suggests that the
SPX rallies in the last 5 weeks or so were narrow and somewhat
artificial, driven by mainstream-trader enthusiasm for their usual
loves of tech stocks and financials instead of being broad-based.
The XLB/SPX Ratio suggests the broad-market SPX pullback actually
started in mid-September!
This has all kinds
of implications for commodities-stock traders. In pure SPX terms, a
meaningful pullback is still overdue. And when the SPX falls
fast enough and long enough to spawn some real fear, economic
worries will multiply and commodities stocks will be sold
aggressively. Investors looking to add commodities stocks should
wait until this pullback matures so they can attain much lower
buying prices. And speculators can play both this pullback?s
initial downside as well as its subsequent sharp rebound.
In the financial
markets, knowledge truly is power. If you understand what is
likely to happen (and why) before it actually happens, you gain a
huge edge that nets big additional profits. I founded Zeal to help
private investors and speculators thrive, to learn what is going on
and apply it to growing your own fortune through buying and selling
stocks. By studying the markets and learning what drives them, you
can get smarter and radically increase the odds of achieving your
financial dreams.
We?ve been
specializing in commodities stocks since 2000 when only the
hardest-core contrarians even knew they existed. Over the 9 years
since, we?ve launched 209 stock trades in our acclaimed
Zeal Intelligence
monthly newsletter with average annualized realized gains of 37%.
Subscribe today
and start growing your practical understanding of the exciting
commodities-stock realm! First-time e-mail-PDF-edition subscribers
will get a complimentary copy of our new November letter, detailing
the SPX?s fascinating eighth pullback unfolding despite one of the
most bullish earnings seasons in memory.
The bottom line is
commodities stocks? sentiment and prices are dominated by the
fortunes of the general stock markets. This is especially true when
the stock markets are weak. During such episodes the commodities
stocks are usually sold much more aggressively than the general
stocks. And this is the case even if commodities prices themselves
happen to be relatively strong or even rallying.
In order to
thrive, commodities-stock investors and speculators cannot ignore
the state of the general stock markets. Not even commodities prices
themselves are more important for near-term commodities-stock price
action. The best commodities-stock rallies are largely driven by
general-stock strength, and their best buying opportunities are
definitely driven by general-stock weakness.
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