The stock market is trying to tell us something.
Last week, I wrote about the relative weakness in materials stocks and what it might mean for the broader market. The group rallied briefly but has since given back its gains, and now energy stocks have begun to falter as well.
Many investors might be tempted to bottom-fish in materials given the stocks’ soft relative performance and — in many cases — exceptionally low valuations. But the weakness in economically sensitive names contains a message: Outside of the technology and consumer sectors, the outlook remains extremely challenging.
With that in mind, here are three reasons why investors should exercise patience when looking for opportunities to go long in stocks sensitive to global economic trends:
1.) Underperformance in a Rally Indicates Continued Weakness in a Subsequent Downturn
Materials and mining stocks have lost ground year-to-date even as the broader indices have soared, largely on the strength of epic rallies in a few select stocks, such as Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT). If these groups couldn’t rally when the market was soaring, it is likely they also will underperform on the way down. With the VIX in the mid-teens and the broader indices still within a few percentage points of their recent highs, the odds are beginning to mount against the type of massive broader-market rally it would take for materials stocks to embark on a sustainable upturn.
2.) The Charts
The technical picture has become more challenging. Even as the major indices have rocketed to new highs, key stocks have failed at their 200-day moving averages and, in some cases, never came close to re-taking this important technical level.
Freeport-McMoRan Copper & Gold (NYSE:FCX), BHP Billiton (NYSE:BHP), Alcoa (NYSE:AA), Market Vectors Steel Index ETF (NYSE:SLX) and Market Vectors Coal ETF (NYSE:KOL) are among the important stocks or ETFs that have failed in this regard.
Further, the iShares Trust FTSE China 25 Index ETF (NYSE:FXI) and iPath Dow Jones UBS Copper Subindex Total Return ETN (NYSE:JJC) have slipped below their 200-day MAs, while the downturn in Select Sector Materials SPDR (NYSE:XLB) and Select Sector Energy SPDR (NYSE:XLE) had brought these ETFs to within 3.8% and 2.7% of their 200-days, respectively, as of late Thursday morning. The recent weakness also has caused both ETFs to drop below their 50-day moving averages.
Is this what a bull market looks like?
3) Valuations Don’t Matter
Many of the stocks in materials look like great buys here, with forward P/Es in the single digits. Unfortunately, materials stocks tend to overshoot on the downside regardless of valuations. If the broader market turns lower, don’t expect low P/Es to provide any support here.
How to Trade Materials Now
These stocks are going to be a phenomenal trading opportunity … at some point. Once investors become more comfortable with the outlook for China, the upside potential is enormous in names like Freeport and Vale (NYSE:VALE). This turn might come as soon as the late second quarter. However, the severe underperformance of materials stocks year-to-date indicates that this time is not yet at hand.
For those looking to trade this group from the long side, the need for stops is paramount. If you see an opportunity to get long, be sure to protect yourself.
Also, the lesson of the past week is that the materials sector still is in a mode where investors need to take profits quickly. While it usually pays to let winners run, this isn’t one of those times — if you have a gain, book it and move on.
If copper and FXI begin to rally, or if XLB shows that it can hold its 200-day, a different approach might be in order. For now though, caution is the name of the game.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.