The Basic Materials sector plummeted from my top U.S. Sectors ranks this week, so I decided to take a closer look at each model component. My U.S. sector model is heavily weighted towards momentum indicators, but I have built in several other indicators that act as a counterbalance.Basic Materials have been a top performer over the past 90, 180, and 250 days. By those measures, this sector is a text book candidate to outperform other sectors over the next few months. However, the Basic Material sector also has several technical negatives to contend with.
First, this sector is overbought. Note the pink bands on both the short term and intermediate term TRIX in the chart above. Even in a bull market, overbought conditions usually signal a pause in upward ascent. What I can't show here is a chart from Jason Goefert of Sentimentrader.com (It's a subscription service). The Rydex Basic Materials sector fund assets represents 18.3% of all sector funds. That's pure irrational exuberance. Also, the charts on the Proshares Ultra Basic Materials and Ultra Short Basic Materials Assets illustrate sentiment extremes that don't exactly give a contrarian a warm and fuzzy for further gains.
Extreme optimism is only one reason to raise an eyebrow about Basic Materials. I've studied technical analysis for many years, and one of the few reliable indicators that signal market tops is a long term momentum divergence. In the chart above you can see the 60-130-45 Moving Average Convergence Divergence peaked last July. You can also see $DJUSBM continued to climb to ever higher heights. This is a technician's textbook example of a negative divergence - not exactly a bullish sign.
The last bearish tea leaf is seasonality. Historically, May is the beginning of poor performance for the Basic Materials sector. Given that many economist believe the U.S. is in or near a recession, basic materials doesn't seem to be a great place to be for the next few months.
I'd love to hear your thoughts.
5 comments:
The seasonal aspect is interesting and something i had forgotten about. I guess I would ask what sort of peak you think this is?
The peak or some sort of correction like what your mentioned has happening in the spring in past years. if that is the case, after a such a white hot run leading to riots and rationing (probably a different part of the sector than you had in mind) it makes sense that there is a lot of air or excess in there.
I'd have to think that in the longer term the supply demand dynamic will be the most important thing but maybe that's wrong.
I agree, the long term supply/demand dynamic hasn't changeed and still supports higher prices. Any decline in this sector will probably be short lived, but I wouldn't be surprised to see a give back in the neighborhood of 25%.
Don Coxe argues that speculation is not a signficant driving force. He considers that the knock against speculation is "pious" and not based on facts. Emerging growth supports demand and production is behind consumption. There is real data to support these assumptions. He believes that the commodity story remains intact and that the problem riddled story of the financial sector is also intact...despite as many as 9 bear rallies. Where commodity sector is transparent, finacial sector remains opaque.
But, TA discipline sides w/ tom k.
There is negatived divergence on longterm mom pattern...and eventually it will play out, as evident now.
Irrational markets tend to delay the eventual outcomes. This is particularly true of the Basic Materials index, IYM. Crude oil futures have pulled the IYM along the bullish path in May. The last trading day for crude oil futures ceases on the close of business on the last business day of the month, two months prior to the contract month(i.e. the July contract month will expire on the last business day of May). July contracts represent the peak of the summer driving months and peak US demand. Also, recent global geo-political events have increased crude prices.
In my opinion IYM is ripe to fall even moreso. Also, China will show a decline in the consumption of basic materials as noted in the drop off in construction since the beginning of the year. This has led to a drop off in other industries. And the US is buying less and less Chinese products. Basic Materials will succumb to this. Just be patient.
j_shiao@yahoo.com
Long SMN $28.50 as of 5/14/2008.
Will scale in more shares on a time/price basis.
j_shiao@yahoo.com
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