Allocation For Hard Times: Sector Relative Strength In The Current Sell-Off

by: Emmet Kodesh

With the markets continuing their first serious correction (let's hope it is only a correction) since last November, it is useful to consider the sectors and major producers and suppliers of commodities and basic materials that are holding up best. Relative strength in down times may be a critical factor for investment and allocation in the coming months.

To gain various perspectives on sector relative strength I will look at the measures provided by Fidelity and Vanguard's sector ETFs. In addition to the count of the two largest fund groups I will consider the day's and YTD performance of the bellwether companies in my group of major producers and suppliers from mixed industrial and basic materials like United Technologies (NYSE:UTX) and Rio Tinto (NYSE:RIO) to a prominent consumer discretionary like McDonald's (NYSE:MCD).

Consumer Staples and Health Care showed the most traction June 24. Since February I have been recommending them as spaces for investment because of my view that the markets have outrun an economy with fundamental problems like declining net worth, income and hours worked. With the S&P down 1.21% to 1573, the sectors and industries overview at Fidelity for June 24 showed Consumer Staples -.47%, Health Care -.75% and Telecom, the second smallest sector -.54%. The worst performers were Industrials -1.65%, Basic Materials -1.68% and Financials, an area of high risk and potential contagion for the indices and entire economy down 1.80%.

Vanguard's ETF's show a similar picture and reinforce thoughts on how best to weather stormy times. Consumer Discretionary (NYSEARCA:VDC), -.48% had the most traction among equity ETFs followed by Health Care (NYSEARCA:VHT) -.78%, Consumer Discretionary (NYSEARCA:VCR) -.95% and Utilities (NYSEARCA:VPU) -1.11%. US Real Estate (NYSEARCA:VNQ) -1.40%, Energy (NYSEARCA:VDE) -1.51% and Industrials (NYSEARCA:VIS) -1.67% lagged the S&P with Real Estate, domestic and international (NASDAQ:VNQI) -1.81% rapidly sinking from 52-week highs toward yearly lows. Rising bond yields have hurt and continue to depress REITs and, more importantly, the nascent US housing recovery which in turn will hurt consumer spending and could end in recession.

As noted in my previous two pieces, the current sell-down is an across-the-board risk-off flight to cash that sees bonds, equities and commodities falling together. High Yield bonds had another bad day, extending the decline of the past month with Barclays ETF (NYSEARCA:JNK) -1.12% and Vanguard's intermediate term (4.6 year average duration) high-yield fund concentrated in Baa3 - B3 bonds ("good junk") down 1.01%. There also were significant plunges in investment grade bonds whether short term (NASDAQ:VCSH) -.47%, intermediate (NASDAQ:VCIT) -.59% or long term VCLT) -.71%. Note that the Vanguard long term bond ETF differs from readings on the 10-year T-bill as the former contains issues with durations from 10-25 years and it yields 4.28%. The main point is that the heavy and continuing drop in bond asset values is another blow for savers and those living on fixed income who need to make periodic withdrawals because the nominal value of holdings falls as rising yields fail to keep pace with dropping asset values. This is the painful scenario that has been lurking since the Fed began QE and increased with Operation Twist.

The takeaways from this part of the sector overview show that preservation of capital in difficult markets will be achieved best by Consumer Staples, Health Care and short term corporate bonds. Hopefully readers have followed my suggestions this year to play these sectors, to underweight bonds and stick to short durations. Those who have cash reserves can add to intermediate and short term issues after bond prices stabilize, but that may take awhile.

For those wanting to avoid further loss of principal and volatility this is a good time to increase cash position. National Industrial PMI is in a clear 4-year downtrend and now in contraction territory (49). Add to this heavy taxes, huge budget deficits, national debt and debt creation it is difficult to be sanguine about this economy or the world economy. A grim snapshot is provided by the relevant Vanguard ETFs: on June 24 the Total World ETF (NYSEARCA:VT) was -2.41%, Total International (NASDAQ:VXUS) -3.27%, ex-US small cap (NYSEARCA:VSS) -2.81% and Emerging Markets (NYSEARCA:VWO) -3.57% on triple its usual volume. This is a time to trim or avoid international equities as extreme volatility and declines in Japan's bond, equity and currency markets, recession in Europe and growing debt and contracting industrial PMI in China all signal that US markets, challenged though they be are less bad than others. As I write, at what is Tuesday afternoon in Asia, the Nikkei index is down 2.13% and China's CSI 300 is -2.5% portending a difficult Tuesday for US markets. Copper (NYSEARCA:JJC) which often is followed as a barometer of global growth was -2.20% June 24 and made a new 52-week low at $36.87 intraday.

Rounding out a view of the markets and underlying economy are my group of basic producers and suppliers. All were deeply in the red June 24 with the exception of MCD which managed a slight .06 gain. Notably, Barrick Gold (ABX) by early afternoon had recovered from an early plunge and was +.36% but sagged to a -1.81% close. In this, however, it fared better than the two other major precious metal producers Goldcorp (NYSE:GG) -4.11% and Newmont (NYSE:NEM) -3.43, both of which touched new 52-week lows intraday. Values are there for those with investable cash and tolerance for risk and volatility. Dividends and intrinsic value in these companies are high but potential investors (and those already in the sector) should note that Goldman Sachs again dropped its 2013 and 2014 target prices on gold to $1300 and $1050 respectively. When GS dropped its estimates and called for short selling gold April 10-16 it pushed precious metal prices through frequently tested support levels to the current $1284/oz for gold. The assumptions supporting the newly lowered estimate, a "continued recovery" in the US economy may be inaccurate. However, as I have discussed in previous pieces, fundamentals and a constructive macro-situation in the PM sector have limited predictive value at this time.

Major mixed commodity miners under-performed falling markets as they have regularly done the past two years. BHP Billiton (NYSE:BHP), RIO, Freeport McMoRan (NYSE:FCX), Southern Copper (NYSE:SCCO) and Vale (NYSE:VALE) all made new 52-week lows. Collectively this augurs poorly for global economies, wealth creation and growth. As usual YTD, BHP was least bad (-2.61%) and VALE worst (-5.20%) in the group. A perfect storm of resource nationalism and selectively applied environmental concerns seems designed to contribute to global impoverishment in which everyone will lose while the worst polluters continue business as usual.

Chemical giants Dupont (NYSE:DD) -.47% and Dow Chemical (NYSE:DOW) -.86% were the least bad among major mixed industrials but steel companies Arcelor (NYSE:MT) -3.12% and Nucor (NYSE:NUE) -1.98 had a bad day with MT making a new 52-week low. Construction companies in industry like Caterpillar (NYSE:CAT) -1.92, agricultural and other systems like Kubota (KUB) -4.92%, Halliburton (NYSE:HAL) -2.01% and Deere (NYSE:DE) -1.78% all underperformed the markets which clearly are being held back from calamitous declines by Consumer oriented companies and the Health Care industry. But these two sectors do not foster organic and sustainable economic growth.

Major energy companies declined with or slightly less than the indices. Chevron (NYSE:CVX) fell -1.91%. Royal Dutch Shell (NYSE:RDS.B) -1.01, Exxon (NYSE:XOM) -1.12% and British Petroleum (NYSE:BP) -.48% had some traction that may show to advantage when economies or economic outlook improve. These energy giants and major miners like BHP, RIO and FCX will prosper if growth resumes and will hold up best if it does not. For safer havens in difficult times, stay with consumer staples ETFs or companies and Health Care. In 7-10 days the PMI reports may give us a clearer picture of whether and when firming business and working basics will curtail the current correction.

Disclosure: I am long GG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own PM companies in two diversified funds and several ETFs.