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Basic Materials Underperform

02/21/2013

The S&P 500® Index (SPX) traded down (-1.24%) to close at 1511.95 on Wednesday, February 20, 2013. Basic materials led the decline as the SPDR Materials ETF (XLB) fell (-2.81%). While the SPX still enjoys a robust 2013 year-to-date performance of +6.013%, the basic materials sector is now only +1.438% for the year.

Within my  Q1 Playbook “It Remains a Bond Friendly World,” I addressed basic materials and commodities in one of 12 investment themes I offered, as follows:

“6. Investors should continue to favor natural gas while increasing exposure to copper and steel. Coal is still to be avoided. Gold, silver, and agriculture allocations should be lowered. The spot price of oil should not be used as the determinant of energy investment allocations.”

For those investors that did increase exposure to copper and steel, I now suggest tactically reducing that exposure back to market weight. This is not to suggest a “short play” on copper and steel, rather an opportunity to take profit. In addition, I would currently maintain the basic materials sector at an underweight relative to the other major sectors.

Currently, 28 of the 30 SPX basic materials corporations have reported their earnings for the period of October 1, 2012 to December 31, 2012. As reported, sales growth contracted (-1.11%) while EPS growth was +10.98%. That translates to a +1.34% positive surprise for sales growth and a +7.22% positive surprise for EPS growth. The anticipated earnings recovery for the quarter should now be viewed as “priced in.”

Other observations relative to basic materials and commodities:

  • Iron ore prices (Figure 1.1) are near their highest levels since the fall of 2011. In a world of tepid economic growth, buyers of the steel-producing raw material may pause on purchases at these price levels. However, tactical investors should be alert for any positive global growth surprise to increase allocations once again. 
  • Inventories of copper (Figure 1.2), which had been in steady decline since late 2011, have begun to build once again. Concurrent with rising inventories the spot price of copper (Figure 1.3) has experienced a February selloff.   
  • The selloff in gold (Figure 1.4) and silver shows no evidence of abating. Longer term support does exist at $1525. However, no allocation increase is currently advised.
  • Refiners maintain their position of secular strength. Energy equities will continue to outperform spot futures pricing (Figure 1.5) as corporations unlock the value of favorable shale positions in Bakken, Eagle Ford, Permian Basin, and Marcellus. Additionally, increasing capital allocation strategies along with potential M&A keeps energy equity names (Figure 1.6) in favor over spot pricing exposure.       

Figure 1.1 Iron Ore Spot Price

Source: Bloomberg

Figure 1.2 Weekly LME Copper Inventories

Source:  Bloomberg

Figure 1.3 Copper Spot Price

Source:  Bloomberg

Figure 1.4 Gold Spot Price

Source:  Bloomberg

Figure 1.5 Brent Crude Oil

Source:  Bloomberg

Figure 1.6 XLE SPDR Energy ETF (Top 10 holdings XOM, CVX SLB, OXY, COP, APC, HAL, EOG, PSX & PXD)

Source:  Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.