Alcoa (AA) released earnings after yesterday's close and beat EPS expectations of $0.08 with a reported result of $0.11. While the metals giant beat on earnings expectations, it fell short of revenue expectations and yet the stock is seeing red after-hours. But in reviewing the call it is clear, it is becoming okay to love the Basic Materials Sector ETF (XLB) again.
XLB and its top holdings have seen reasonable gains since November lows, up nearly 5%. However, the ETF has been lagging its more defensive peers and even the S&P 500 ETF (SPY) over the short term. The market has undervalued the XLB, especially on a short-term basis. Equities' advances are unlikely to continue without the XLB, this is supported by the fund's relative strength index, which continues to reflect an oversold status. Long positions in the XLB benefit from positive guidance and earnings beats of its holdings like Alcoa. The Yahoo! Finance chart below indicates the drastic outperformance of the S&P 500 against the XLB over the past three months, which is not justified given the bullish expectations for the larger market.
The fund and its holdings have recently experienced underperformance for various reasons including decreasing commodity prices and uncertainty from global markets like Europe and China. Fortunately, these concerns have led to weak estimates and low intrinsic values that are simply over-exaggerated. The RSI (10, 1d) for the XLB is a nearly oversold 36.55 with some of its top holdings' RSI values indicating value like DuPont (DD) at 36.72, Dow Chemical (DOW) at 16.98 and even Alcoa at 45.00 could be very attractive if too many panic about the top line revenue estimate miss.
Going back to Alcoa, the touted bellwether for earnings season provided mixed results with respect to expectations, beating on earnings but falling short of revenue expectations. After reviewing the transcript (which can be found here), aside from its revenue shortcoming, its CFO William Opplinger was positive about the reallocation of demand. He stated in the call that "Aerospace volume increases and productivity gains across all businesses more than offset weak nonresidential construction and commercial transportation markets...we anticipate continued share gains through innovation and productivity improvement. So in aggregate, EPS had an excellent first quarter, and better still we're projecting profitability to continue to grow by roughly 5% in Q2."
Opplinger went on to say "money has been flowing into equities and out of commodities, driving commodity prices lower overall, and aluminum has been no exception. However, while I can't speak for the other metals, the decline in aluminum prices is not reflective of the overall current market fundamentals. We continue to project 7% annual consumption growth, and coupled with recent curtailments in China, we've actually tightened our supply demand projection."
Beyond aerospace, Alcoa provided guidance that it expects to benefit from pent up demand in the automotive industry, which many parts of the XLB would also enjoy. Alcoa CEO stated during the call that he expects fleets to begin to replace aging vehicles "the average age of the fleet today is 6.7 years, and if you compare that with the 20-year average of 5.8 years, you actually see that there's quite a bit of pent-up demand sitting in this segment in North America, which gives us confidence here."
The guidance given from Alcoa is very positive for XLB and while Alcoa is just under 2% of the holdings for the XLB, it is an indicator for other metal and mining companies in the fund. The guidance also speaks to a broad bullish sentiment in equities when the CFO speaks of the cash inflows into equities. Finally, for Alcoa, there is additional upside as short interest sits at 6.47% of float, as short positions are closed, the stock will squeeze higher.
Moving to a bigger allocation of the fund, Monsanto (MON) also received some positive attention from Goldman Sachs (GS), as the analyst there raised their price target to $122 from $116, now a 16% increase from yesterday's close. Meanwhile, DuPont, like Alcoa has a large short interest of 3.78% of float, which could catalyze a squeeze higher for the stock and the XLB.
Intuitively, this underperformance seems to be crowd induced. Given that consensus is bullish for equities whether that is based on dovish Fed policy or the idea that investors will see relatively consistent earnings despite weaker estimates, an undersold ETF and its holdings amid increasing cash inflows into equities is very attractive at the moment. If investors are uncertain about macroeconomic events, they should not sell solid companies with positive guidance like Alcoa, they should instead buy volatility for protection through the Short-Term Volatility Futures ETF (VXX) as it will account for any major macroeconomic event that could ignite severely negative price swings that would affect the S&P 500. Further selling is misplaced in the XLB and is actually more appropriate in an ETF that actually needs a breather from its bull run, the Consumer Staples Sector ETF (XLP).
Using the Health Care (XLV) and Consumer Staples Sector ETFs as a comparison, the XLB is as underperforming the SPY to relatively the same degree that the XLV and XLP are outperforming the SPY. This largely reflects a flight to "defensive sectors" due to already known macroeconomic concerns stemming from headlines about overblown issues like Cyprus, sequester cuts, and "altitude sickness" around the all-time highs recently reached in the U.S. equity indexes. Look for the XLB and its holdings to revisit and surpass their 4-week highs if they can beat the low Q2 estimates as Alcoa has done. Ultimately, the over-exaggerated sentiment against materials has dragged prices down for the XLB and its holdings. Guidance like that of Alcoa proves sellers wrong while increasing price targets for Monsanto from the likes of Goldman support the expected upside in this space.