7 Reasons Materials are Poised to Break Higher

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Materials may be in the process of switching from market laggards to market leaders. Below we outline six reasons basic materials are worth keeping on your radar:

  1. Commodities have flipped to a bull market.
  2. Materials (XLB) have cleared a key moving average.
  3. The U.S. Dollar is weakening.
  4. China is stimulating demand.
  5. XLB has successfully retested a key support level.
  6. Global monetary conditions are favorable.
  7. XLB is gaining strength relative to the S&P 500.

The Materials Select ETF (XLB) is highly correlated with commodities, and thus should benefit from the recent appreciation in hard assets. From Bloomberg:

Commodities surged from a bear to a bull market in anticipation of economic stimulus measures from the Federal Reserve, completing the fastest turnaround since the depths of the financial crisis starting in 2008.

In periods where central banks are flooding the global banking system with freshly printed money, investors tend to migrate toward inflation-protection assets, such as copper, silver, gold, and oil. The most recent move toward hard goods and basic materials can be seen below. The monthly chart of XLB below favors bullish outcomes for materials and the S&P 500. The slope of the 14-month exponential moving average (EMA) is in the process of turning up in a bullish manner (thin blue line).

xlb 11 sep 2012 moved about its 14 month ema

With more quantitative easing (a.k.a. money printing) expected from the Fed, the U.S. dollar is helping build the case for commodities and basic materials. From Investor’s Business Daily:

“Another arrow in the bull’s quiver is the breakdown in the U.S. Dollar Index,” wrote Mark Arbeter, chief technical strategist at S&P Capital IQ, in his weekly technical report. “In recent years, some of the best gains in stocks, as well as commodities, have come during periods when the dollar was falling, and we aren’t going to argue with prior intermarket price relationships.”

China is moving toward additional stimulative measures to boost slowing economic growth. Since infrastructure projects are expected to be part of the Chinese package, demand for basic materials will be given a boost. According to a September 12 Bloomberg story:

China’s stocks rose for the fourth time in five days after Premier Wen Jiabao signaled the government has more room for fiscal and monetary stimulus measures to boost economic growth. Anhui Conch Cement Co. and Sany Heavy Industry Co. led gains for construction-related stocks on speculation they will benefit from government spending on infrastructure. Jiangxi Copper Co. (600362) surged 3.3 percent on the prospect the U.S. Federal Reserve will increase stimulus by buying bonds, bolstering the outlook for commodities demand.

From a technical perspective, XLB recently cleared the downward-sloping blue trendline (see A below). The purple arrow shows a successful “confirmation” of the bullish breakout. Line A previously acted as resistance; now it is providing support. The green arrows show XLB making a higher low. The green parallel trendlines (B1 and B2) appear to be forming a bullish trend channel. XLB has “white space” above if it begins to head toward line B2 for a third time.

xlb 11 sep 2012 materials complete bullish turn

Bloomberg highlighted the primary drivers behind the recent pop in commodities:

“Commodity prices are poised for a good second half,” Harry Tchilinguirian, BNP Paribas SA’s head of commodity-markets strategy in London, said by phone. “After the risk-off correction in the first half of this year, global monetary policy easing alongside individual supply constraints provide a positive outlook for commodities.”

Another good sign for basic materials is the improving performance of XLB relative to the S&P 500 (shown below). The first step toward materials possibly providing leadership was completed when the blue trendline was broken in a bullish manner (see 1). The second step for a trend change was completed when the ratio (XLB:$SPX) made a higher low (see slope of green line near 2). The third step will be knocked off if the ratio can clear the dotted green line, which represents a higher high.

xlb spx 11 sep 2012 materials relative to s&p 500

The numerous bullish set-ups we outlined on September 7 remain in place. For materials and the general market to break higher, the bulls must avoid an unexpected bearish outcome from both Germany’s high court and the Fed.

Source: Ciovacco Capital

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About Chris Ciovacco