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 wellCommodities-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.
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.
Adam Hamilton,
CPA
Zealllc.com
November 6, 2009
Also
by Adam Hamilton
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