Commodities Provide Refuge in Broad Market Turmoil

Continued poor performance by the very sector that acts as the glue for capital markets has a nasty habit of unhinging the markets all together, creating wide instability across a menu of sectors, asset classes, and the market in general.

It’s unfortunate then for bulls that financials will continue to serve as the market’s 800 pound anchor, dragging stocks down at worst, and keeping them from moving forward at best. Many traders are now cautiously calling a bottom on financials, but they will have to keep searching, because the end ain’t here yet. While valuations on financials have come down quite a bit, and large sums of money have been written off, there is still plenty of turmoil to come. Ordinary people are struggling with rising commodities prices, increasing monthly mortgage payments and an upward trend in inflation. They are struggling to make credit card payments and cover their mortgage payments in full every month. Plenty of people are walking away from homes they have sunk tens of thousands of dollars into.

Of course, none of this is good for financials, and as their liquidity begins to tighten as a result, fresh rounds of capital raising will be on the way. While U.S. financials certainly still stand to suffer, we’re not going to see the same level of selling the market experienced in the past six months. In the U.S., many financials have gotten through the worst of the storm, though they’re not entirely safe yet.

The real trouble ahead lies in the European financial markets, where like in the U.S., rising housing costs have become very problematic. Commodities are rising steadily in Europe as well. These fundamental pressures on the ordinary man are quickly rising toward the European banks, who are now maintaining nearly three times the leverage of their U.S. counterparts. We’ve seen the deadly combination of poor performance and high leverage in the U.S., and it’s very clear: when the bullet hits European financials, it will hit hard. There is no great way to trade a negative outlook on European financials in one fell swoop, but shorting iShares S&P Global Financials Sector ETF (IXG) provides better exposure than say, the Financial Select Sector SPDR ETF (XLF).

With that said, the imminent earnings report from Fannie Mae (FNM) could send the financials, and the market in general for an interesting jolt in the very near term. I suspect we’ll get good news from Fannie, and subsequently see it recover from the punishment it took on the Freddie Mac (FRE) earnings, but I really don’t know. It’s tough to have confidence one way or the other in the current environment.

The recent rally in financials has been due largely to falling oil prices, which have propped up the market as a whole over recent days. While oil stood to take a wild downward slide after encountering the intimidating psychological mark of $150/barrel, it has now clearly gone too far. There has been solid support for oil in the upper 120s, and we should see a climb back to those levels soon. Oil has had a nice bit of help on the way down: positive developments in Iran, solid rhetoric from the Obama camp, and generally favorable geopolitical developments. The good news has run out. $130/barrel, look out.

As a result of continued trouble in the financial sector, I feel as if commodities are a good place to take refuge. Yes, they have risen quite a bit of late, but the market conditions driving their upward movement are still very much alive. I particularly like coal at the moment. It has taken quite a beating this week, only to recover somewhat on Wednesday. In general, it is highly undervalued in the current market, but that error will quickly be corrected. Market Vectors-Coal ETF (KOL) is a good ETF play, and Arch Coal Inc. (ACI) is a standout individual pick. ACI has huge reserves, and are well positioned to benefit from clean coal initiatives both now and in the future.

In the end, we are still in a bear market cycle, and traders should be mindful of this fact as they begin to call bottoms across the market. Things are still quite hot, and it’s not hard to get burned. With the Olympics kicking off, I’ll talk China tomorrow, and give my continuing vision for the market.

Thanks for taking the time to read my thoughts. 

Disclosure: Author holds a long position in ACI