Materials Evidence

 | Jul 16, 2013 | 5:00 PM EDT  | Comments
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Stock quotes in this article:

bhp

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fcx

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btu

In the short run, the market is a voting machine but in the long run it is a weighing machine. --Benjamin Graham

There's been a sea change in sentiment from a steady increase in bond yields. It has brought not just a rotation out of bonds but out of defensive names as well, including steadier dividend stocks. The recipient asset class? In May and June it was cash: We can tell that from the pullback in the last two months. But more recently, money has been flowing into "growth" sectors. Materials, a long-suffering sector, seems to have finally caught a break, especially the miners. Is this the all-clear that they have finally bottomed out?

The Voting Machine

Materials have no doubt staged a comeback this month. In no place is this as apparent as with the miners. Freeport McMoRan (FCX) has bounced 4.7% from a $26.85 low late last month. Coal giant Peabody Energy (BTU) has jumped 8.5% from its July 1 low. And the largest of the miners, BHP Billiton (BHP), recovered 7.9% from its early July lows.

Investors fearing higher rates are cycling out of defensives and bonds in favor of cyclical names. And technically speaking, it does look like these three have indeed bottomed. But do higher rates really signify a cyclical turn? Or are materials just the flavor of the month? In rushing for these mining names, U.S. investors are taking domestic interest rate cues while ignoring global realities.

The Weighing Machine

Yes, the U.S. economy may be accelerating; however, the global picture is not as nice. Europe is still struggling to tread water and many countries are either in recession or teetering on the brink of it. But this really isn't about Europe or the U.S. Neither are the deciding factor for Materials; emerging markets are -- and they aren't treading water. They're decelerating, and decelerating quickly.

China, which at one point consumed about half of the world's iron, copper and metallurgical coal is dropping off fastest of all. Chinese demand for all these items is leveling off. While interest rates may signal an improving picture here, the "commodities supercycle" is ending.

In no company is that more apparent than the world's biggest resource, BHP Billiton. BHP supplies iron ore, manganese, copper, aluminum, coal and some petroleum. Of the big three miners, BHP is arguably the best operator. But even the best is not doing so well right now.

Sources: BHP Billiton

This is not the kind of chart indicative of a recovery in profits. Despite renewed interest in this cyclical sector, margins are falling broadly. This earnings drag is a powerful one and it will win in the end.

Conclusion

The commodities supercycle will ultimately trump the Wall Street fashion show. That means staying clear of metallurgical coal, copper, iron and other highly cyclical materials.

But, to be sure, there are some great picks in this space. The miners will be buyable at some point when China's growth rate bottoms out. When or if that happens, BHP Billiton will be a buy. It is the best big resourcer by operating margin and the best bet for when mining finally does reach rock bottom.

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