Basic Materials Look Attractive Relative to the S&P500

August 11, 2014 8:29 AM

When you talk about underperforming sectors, it’s hard not to bring up the Materials space. Over the last 3 years, Materials have struggled relative to the S&P500 as some of the other sectors like Healthcare and Technology have led the way higher. Based on our ratio analysis, I don’t see a sector with a more favorable risk vs reward disparity, particularly on a relative basis.

Here is a daily line chart of the S&P Materials ETFs divided by the S&P500. The downtrend over the last few years is very clear, but the recent developments lead me to believe that a reversal higher is imminent. First of all, look at the 200 day moving average reverse higher after a year long bottoming process. Price has been consolidating nicely all year above former support and resistance levels (shaded in gray). And finally we can see the down trendline from the 2011 highs get taken out, successfully retested and now trying to make higher highs.

8-11-14 xlb

I think that as long as this ratio remains above the 200 day moving average, this is a space where we want to be exposed. This is especially the case on a relative basis if you want to remain more market neutral. The trade here is essentially Long XLB and short an equivalent amount of SPY. The first target is up near 28, where we run into the early 2012 highs and 61.8% retracement of the entire 2011-2013 decline. I’d be looking to take some off there and reevaluating the situation. But it would not surprise me to see a retest of the 2011 highs up above 30. This represents about a 13:1 reward to risk ratio for the bulls.

Another idea is to take a look at some of the major components within the materials space. Companies like DOW, MON, DD, LYB, and FCX are a few of the largest holdings in XLB. There are plenty of opportunities there while remaining equities neutral. This time of year, seasonally, I find pairs trades to be a huge advantage in achieving that neutral goal. Also look at the analyst ratings, some of the names on this XLB holdings list are very hated by the sell side. The more they hate them, the more I’m attracted. It’s the unwind of this extreme bearish sentiment that I think will help prices go much higher.


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