The Morgan Stanley Commodity Related Equity Index dropped 3.7 percent in the six months ended June, compared with a gain of 13.8 percent for the benchmark S&P 500 Index.
And that wasn’t just a recent phenomenon: As shown in the chart below, commodity stocks have trailed the S&P 500 for over two years — and by a whopping 36.5 percent.
But there is some potential good news for natural-resources stock investors: The long down trend has leveled out, and commodity stocks may be poised to outperform once again, though perhaps not for the reason that most investors suspect.
Since commodities, and resource stocks, began dramatically underperforming two years ago, investors have been concerned about a stubbornly slow-growth world. The IMF, which closely tracks global economic trends in its World Economic Outlook report, has consistently cut worldwide growth forecasts, including in its latest bulletin here.
Fears of a global double-dip recession have been a persistent source of market stress in recent years, and central banks have responded with massive money-printing in response to the deflationary threat.
The chart below displays the global downshift in growth. It shows the Purchasing Managers Index (PMI) for Europe (top panel) and China (bottom), a widely followed indicator of industrial strength.
You can clearly see that the down trend in the PMI since 2011 reflects the underperformance in commodity stocks. Although data out yesterday shows a slight pick-up in Europe, the region is still mired in a recession, and there are growing concerns about a “hard landing” for China’s economy, which has already slowed from growth rates of 10 percent-plus just a few years ago to 7 percent today.
With these stiff economic headwinds on the horizon, why should commodity stocks outperform again? Perhaps because gains in commodity prices may have less to do with swings in global growth and more to do with the trajectory of the U.S. dollar.
Let’s test this theory using China as an example.
The consensus view has always been that China’s insatiable consumption of raw materials — especially industrial metals like copper, iron and aluminum — has been the primary driver of the long-term commodity bull market. China’s demand for iron ore, for instance, has increased 10-fold since 2000, while copper imports nearly tripled.
So, the reasoning goes, if China was the force behind the commodity boom of the past decade, perhaps lack of demand caused the commodity bust in recent years. But nothing could be further from the truth.
In reality, China’s demand for basic materials is still growing, perhaps at a slower clip, but the country’s commodity imports are at record levels.
China’s copper imports rose 14.1 percent last year to 4.65 million tons, and aluminum imports are up 9 percent year over year through May. Shipments of iron ore bound for China jumped to 743.5 million tons in 2012, up 8.4 percent to a new record. So if China’s commodity consumption remains on a tear, what’s the explanation for the prolonged slump in commodity stocks?
Perhaps we can find an explanation for the downtrend in resource stocks that hits closer to home … the persistent uptrend in the U.S. dollar (NYSEARCA:UUP).
The chart above displays the multi-year trends in the CRB Commodity Index and the U.S. Dollar Index. Look back at the period from 2002 to 2008 at the left, and you’ll see a clear downtrend in the dollar, which was accompanied by a steady uptrend in commodities … and resources stocks.
It’s practically a mirror-image, or in financial lingo, the two indexes have nearly a perfect inverse correlation.
In the immediate aftermath of the financial crisis, this inverse relationship didn’t always hold. Elevated volatility will do that, but commodities and the dollar still moved in opposite directions most of the time.
At right in the chart above, notice that since commodities began underperforming in 2011, the dollar index has been in a fairly steady uptrend — it’s no coincidence.
Over the past few years, in fact, the CRB Commodity Index and the U.S. Dollar Index have had an 80 percent negative correlation, which means that for every $1 increase in the dollar index, the CRB Index falls about 80 cents in value.
That’s an incredibly tight correlation that tells me the real source for the weakness in commodity stocks, and it isn’t China. It’s the strong greenback.
For the past two years, the dollar index has run into resistance near the 85 level and fallen back below 80 each time. This trading range is tightening, which means a major move, either up or down, in the dollar may be coming soon.
On July 9, the U.S. Dollar Index peaked at 84.96, and this week it has fallen to 82.2, which explains the strength in gold, as I pointed out recently, and other commodities.
Natural-resources stocks are beginning to perk up a bit, too. Since July 9, the Morgan Stanley Commodity Related Equity Index has gained 5.6 percent while the dollar declined. This could be the start of a big shift in trend for commodity stocks, and the dollar.
If so, watch for sector rotations in the stock market during the second half of this year. Health-care, consumer-discretionary and financial stocks led the market in the first six months of 2013. But now I’m watching for a big rebound in out-of-favor commodity stocks like energy, metals and mining shares in the months ahead.
The upside potential in certain commodity markets and commodity stocks is huge from today’s discounted prices. The last time commodity stocks were this cheap, in early 2009, the Morgan Stanley Commodity Related Equity Index soared 220 percent over the next two years, far outperforming the S&P 500 Index and the CRB Commodity Index.
So keep an eye on the direction of the dollar. If it’s down, I expect a powerful mirror-image uptrend in commodity stocks, and it may already be under way. One way to play it is with the iShares Global Materials Sector ETF (NYSEARCA:MXI), which holds a basket of 117 commodity-related stocks including undervalued metals and mining shares.
Commodity stocks are under-owned by big institutional investors, and valuations look the most compelling in many years. In other words: Commodity stocks are unloved and oversold, and that’s music to the ears of any true contrarian investor.
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