The Outlook for Commodity Stocks
Leuthold Weeden Capital Management
By Doug Ramsey
December 21, 2012
- Popular sentiment holds that commodities remain in a secular uptrend, but commodity-oriented stocks (Energy and Materials) have been underperforming for more than a year-and-a-half. We’re increasingly convinced their 2008 relative strength highs won’t be challenged for a very long time.
- Yes, Emerging Market demand may rebound next year. But remember Econ 101, and the day your professor discussed supply? This side of the equation doesn’t look as good.
- Among the two commodity-based sectors, Energy looks cheaper and appears much more washed out from a sentiment perspective. Contrarians looking for commodity exposure should favor this sector over Materials.
A common presumption among stock market investors seems to be that the 2008-09 market and economic meltdown only temporarily derailed what remains an Emerging-Markets led, secular bull market in commodities. These bulls have a few data points on their side — notably the move in the CRB Raw Industrials eclipsing its 2008 high in early 2011, a mere two-and-a-half years into the recovery.
We didn’t expect industrial prices to rebound as powerfully as they initially did, but not because we doubted demand (especially from Emerging Markets) would rebound rapidly. Instead, we thought growth in production capacity for both energy and non-energy industrial commodities might temper the price rebound. While we underestimated the commodity price rebound, the relative price action of commodity-oriented equities has lately borne out our fears. Both the S&P 500 Energy and Materials sectors are 11-12% below their spring 2011 peaks, and neither group is too far above the relative strength lows they made during the meltdown (Materials) or somewhat afterwards (Energy in 2010). We’d be careful about buying into this price weakness.
Commodity Prices vs. Commodity Stocks
How closely do the stock prices of commodity producers track prices for the underlying commodity? Over the past several years, investors in gold mining shares have learned the painful lesson that the connection can be either weak or nonexistent. But, from a broader perspective, the relative price action of the S&P 500 Materials sector has tracked the inflation-adjusted CRB Raw Industrials quite well over several decades, with the cyclical peaks and troughs in both series generally coinciding (although the inflationary 1970s proved an exception, as shown below).
Focusing on recent action, we consider it a longer-term bearish omen that the S&P 500 Materials sector failed to reach a new relative strength high when the “real” CRB Raw Industrials eclipsed their 2008 high in early 2011.
The link between oil prices and Energy stocks has suffered an even more decisive breakdown post-2008. S&P Energy “relative” valuations tracked crude prices quite closely throughout the 2001-2008 oil boom; however, today’s Energy sector relative valuations stand near their early 2009 lows — despite the doubling of the inflation-adjusted price of crude. Rising oil extraction costs are no doubt a partial cause for this “correlation breakdown.”
Don’t Overlook The SUPPLY Side…
Virtually every bullish argument we hear for commodities is a demand-side one. While we recognize that economics as a profession has suffered a heavy reputational hit in the past few years, there’s no reason for analysts to entirely abandon the other half of the dismal science (i.e., supply).
While economic script-writers still ascribe last decade’s commodity boom to Emerging Market demand, we wrote (particularly during the “Third Act” of the cycle from 2005-07) that capacity restraint was an equally critical force behind the massive price jumps in energy and non-energy commodities in the cycle’s final phase. In Energy, capital spending did not begin to ramp up until mid-decade, while the situation in Materials was even more bullish, with capital expenditures dramatically below depreciation levels four years into the commodity boom! (See top and middle charts.)
However, capital spending in both sectors eventually (and predictably) went vertical, contributing to the severity of the 2008 price collapse. After a brief post-meltdown respite, capital spending by commodity producers has rebounded to historically high levels in relation to depreciation. In Materials, the recent capex-to-depreciation ratio eclipsed the level seen at the 2008 high. Bulls on Emerging Market demand should consider whether the commodity producers themselves have already ramped up for this demand. If so (and we lean toward this view), commodity prices and profitability might prove disappointing in the quarters (and perhaps years) ahead.
- Capital spending trends point to profitability risk in both sectors. To some extent, these risks have already been realized. The margins earned at last year’s commodity price peaks never approached their record 2008 highs — even though many industrial commodity prices (but not crude oil) did.
- If net margins eventually regress to their 24-year medians, the downside risks are higher in the Energy sector than for Materials.
Commodity Stocks: Valuation & Sentiment
While our analysis on profitability and spending trends highlights the potential risks in both Energy and Materials, comparative valuations suggest investors don’t view these risks equally.
- We built “Relative Valuation Composites” for both sectors, consisting of Normalized P/E Ratios, Price/Cash Flow Ratios, and Price-to-Book Ratios — with all measures subsequently compared to the S&P 500. The results show investors have clearly taken a more pessimistic view on the growth and/or sustainability of profitability in Energy. This sector’s Relative Valuation Composite trades at just a 9th percentile reading in relation to its 1990-to-date history. The median Price-to-Book Ratio for the S&P 500 Energy sector closed November at 1.51; we can find only a handful of lower figures in our database.
Materials investors clearly have adopted the glass-half-full viewpoint, with the sector’s Relative Valuation Composite on the high side of its historical trading range.
- Value managers will probably want to focus more effort on Energy, based on our top-down valuation work.
For more than a decade we’ve tracked equity options data at the sector and industry group levels in hopes of building a useful “contrary opinion” tool. Ultimately, their predictive window appears too short-term for use in our broad Group Selection framework. However, I still review these charts for potential contrarian themes. Lately, we’ve seen fairly heavy put-buying on Energy stocks — a short-term (contrarian) positive for this sector.
Commodity Stocks And The CPI-PPI Spread
In 2008 we introduced a “Profit Margin Indicator” to identify whether relative inflation trends favored Commodity sectors (Energy and Materials) or Consumer sectors (Consumer Discretionary and Consumer Staples). Our simple margin proxy is the spread between Consumer Price Inflation and Producer Price Inflation (with the latter measured by the PPI-All Commodities).
- A positive spread between Consumer and Producer Price Inflation tends to favor Consumer Goods producers; our Consumer Goods composite outperforms the Commodity stock composite by about 600 basis points annually during such periods.
- On the other hand, in a negative spread environment (PPI inflation exceeding CPI inflation), Commodity stocks outperform Consumer Goods stocks by about 700 basis points annualized. Note this spread was negative (and very large) during most of last decade’s commodity boom.
- In the wake of recent commodity weakness, the CPI-PPI Inflation spread has jumped back into positive territory — an historically bearish sign for the relative price action of Commodity-oriented stocks versus Consumer Goods stocks. We don’t want to overplay this, because this relationship (like other relationships between the economy and stock prices) can be unstable. But it supports a more bearish stance on Commodity stocks.
Post-Script: Are Energy Stocks A “Short-Term” BUY?
We’re not “secular” bulls on either Energy or Materials stocks, but we remain alert for shorter-term opportunities to “rent” these stocks (for perhaps a year at a time). From this analysis, Energy might offer contrarians better odds for such a “rental” than Materials. As noted, their valuations are considerably cheaper, with our S&P 500 “Energy Relative Valuation Composite” in its historical bottom decile. In line with these cheap valuations, options activity reveals fairly heavy bearish betting (i.e., put buying) on Energy sector equities.
Cheap valuations and low expectations are all well and good, but where’s the catalyst? Consider the Energy sector “Smart Money” model we built in 2006 (shown below). For a BUY signal on Energy stocks, we’re seeking the combination of: (1) significant intermediate-term weakness in crude oil prices — indicated by a 10-week decline of 10% or greater; and (2) evidence that “commercial hedgers” in crude oil futures are responding to the price drop by sharply curtailing short positions (indicated by the “indexed” net position rising to a level of 90 or above).
On November 30th (the latest weekly reading before publication), the Smart Money Model was only pennies away from issuing a new BUY signal. Past BUY signals have done a pretty good job of catching intermediate-term relative strength lows in the Energy patch.
Visit www.leutholdfunds.com for further information and research.
This report is not a solicitation or offer to buy or sell securities. The Leuthold Group, LLC provides research to institutional investors. It is also a registered investment advisor that uses its own research, along with other data, in making investment decisions for its managed accounts. As a result, The Leuthold Group, LLC may have executed transactions for its managed accounts in securities mentioned prior to this publication. The information contained in The Leuthold Group, LLC research is not, without additional data and analysis, sufficient to form the basis of an investment decision regarding any one security. The research reflects The Leuthold Group, LLC’s views as of the date of publication, which are subject to change without notice. The Leuthold Group, LLC does not undertake to give notice of any change in its views regarding a particular industry prior to publication of their next research report covering that industry in the normal course of business. The Leuthold Group, LLC may make investment decisions for its managed accounts that are inconsistent with, or contrary to, the views expressed in current Leuthold Group, LLC reports. Weeden Investors, L.P., Weeden & Co., L.P.'s parent company, owns 22% of Leuthold Group’s securities. A Managing Director of Weeden & Co., L.P. is a member of The Leuthold Group, LLC board of directors. Weeden & Co., L.P. member FINRA, NASDAQ, and SIPC.
© The Leuthold Group 2012