Increased demand for raw materials and a surge in
manufacturing activity has made basic materials ETFs into market
darlings. But manufacturing activity typically increases when
economies emerge from a recession. Now the recession is a year
behind us. Is manufacturing growth strong enough to support
further outperformance of materials ETFs?
Basic materials ETFs hold companies producing chemicals,
industrial metals, timber and agricultural products. They control
raw materials essential to production. The sector is highly
cyclical. When manufacturing collapsed in the final quarter of
2008, materials ETFs lost 50% of their value. Most of those
losses have since been reversed- but not all.
The chart below shows this. It compares the 5-year performance
of the Materials Select Sector SPDR (NYSEArca:XLB) and the
iShares Dow Jones Basic Materials (NYSEArca:IYM).with the
benchmark Standard and Poor's Depositary Receipts
The chart shows the volatility and cyclicality of the
materials sector. Basic materials ETFs outperformed through the
fall of 2008, before tumbling. The resurgence of global demand in
the second half of 2009 started the rebound. Basic materials ETFs
beat the S&P by a 2:1 margin in 2009, mostly on the back of
government stimulus and demand from the Chinese.
The structure of the industry contributes to its volatility.
Significant fixed assets ensure a high cost to setting up an
operation in the sector. This provides barriers to entry for
competition and allows companies a measure of monopoly pricing.
In a growing economy with demand on the upswing, raw material
companies exert more control. Profits skyrocket. But this
structure is also a curse. Operations are expensive and companies
tend to be so far upstream in the production process that
faltering demand anywhere along the production chain threatens
pricing power. When demand falters, profit disappears. Some
companies even lose money.
Demand is all-important. How is the demand for basic materials
assessed? Most elastic demand for basic materials comes from the
manufacturing sector. The ISM Manufacturing Index is based on a
survey of purchasing managers in manufacturing and monitors
inventories, production, deliveries as well as new orders. The
ISM Manufacturing Index slumped dramatically in the last quarter
of 2008, and has since reversed. The chart below from the St.
Louis Fed shows the 5-year ISM Manufacturing PMI composite
The chart An ISM above 50 indicates growth in the sector.
Below 50 indicates contraction. The shaded area indicates the
U.S. recession. As the chart shows, manufacturing was steady
before September of 2008 when it hit a wall. ISM fell to below 35
in Q4 2008. ISM has been above 55 for most of 2010. ISM for
October 2010 is 56.9%, indicating healthy growth.
Demand for raw materials comes in part from the fast-growing
economies in Asia, particularly China. Over the last decade,
China's strong economy has shifted the demand curve for basic
materials. Today, China's demand is bigger than ever. Flush with
cash, state-owned Chinese companies are actively purchasing basic
materials operations. Basic material and the companies that
produce them have additional attraction for China. Unlike
treasuries bonds and other assets China has accumulated, basic
materials are attractive because like other commodities, raw
materials tend to hold up well in the event of inflation. As
Barrons has reported recently, China is scouring the world-- from
Australia to Africa- for materials. They are buying industrial
assets, they are doing infrastructure deals with governments.
Where they cannot buy the assets or the companies outright, they
are buying big stakes.
Though U.S. manufacturing growth may slow in the next couple
years, basic materials ETFs are a good asset as an inflation
hedge and in light of the growing world-wide demand for materials
and materials assets.
Following is a list of Basic Materials ETFs:
* Materials Select Sector SPDR Fund (NYSEArca:XLB)
* Vanguard Materials ETF (NYSEArca:VAW)
* iShares Dow Jones U.S. Basic Materials Sector Index Fund
* iShares S&P Global Materials Sector Index Fund
* WisdomTree International Basic Materials Sector Fund
* SPDR S&P International Materials Sector ETF
* Powershares Dynamic Basic Materials Sector Portfolio ETF
* First Trust Materials AlphaDEX Fund (NYSEArca:FXZ)
* Market Vectors Steel ETF (NYSEArca:SLX)
* Global Steel Portfolio ETF (NasdaqGM:PSTL)
* Ultra Basic Materials ETF (NYSEArca:UYM)
* UltraShort Basic Materials ETF (NYSEArca:SMN)
has been writing about ETFs since 2003 and is the author of
Sector Trading: A Year in Exchange Traded