Commodities Are Taken to the Woodshed - What's the Game Plan?

The day started out like pretty much every day in the past few weeks. The broader market acts weak, oil remains at its high, and commodities (especially coal and natural gas stocks) make new highs almost daily.

But then we come across the woodshed.

Oh yeah... that looks safe, doesn't it?

Not bloody likely.

The reality is that the commodities trade got WAY over crowded. I mentioned in my Weekly Game Plan, that it was going to be another week of defence. And more importantly, that the risks were mounting in the most loved names.

Some quotes from the weekend game plan:

• "I have to say, that as much as I liked the metallurgical coal thesis 2 months ago, I must be less bullish today."
• "I wouldn't be surprised that many major funds now have significant positions in these names, which are hedging out losses in other areas. This is another reason why panic and fear have not broken out. There's still a place to hide, but that place is getting crowded."
• "This is more of a game of hide and seek with a bear. But everyone is hiding behind the same curtain."

But let's get to the point. What's the gameplan from here on out? First, we need to understand the anatomy of this correction. I wrote a piece earlier about that here. Back on the edge of the Abyss

Another important consideration, is that we need to understand how the market views this correction. Yes, this is the "global growth is dead" battle cry, and since virtually everything is now somehow connected to this thesis, this has the potential to be one ugly correction. And one that is not a "V" bottom.

If we operate under this assumption, we need to realize that the stock market is an expectations game.

What happens tomorrow, next week, or even next month, is not going to depend on whether we get a global recession or not. What does matter is expectations, and that is what we need to be on the look out for. A bottom will occur in commodities when the market has fully discounted a global recession, regardless if it actually happens. So forget about if it actually happens or not. Even if it does, but expectations suggest we don't, we will get a rally.

So what's the game plan?

Again, it's Defence. But this time, we are going to defend the best of breed in the themes and companies we have the most conviction in. Most of the time, I think having the conviction is the most valuable part of fundamental analysis. So circle the wagons around the companies you have the most conviction in.

By far, my favorite theme still surrounds agriculture. A growing middle class in Asia, and to keep civil rioting at a minimum, food ample food will be required. My favorite names are the ones I've been behind for a long time. Agrium (AGU), Mosaic (MOS) and Potash (POT).

Next is deep water drilling. This "global recession" is being partly sparked by oil fears. That's why oil (the commodity) still has not faltered. Stick with Transocean (RIG) and Atwood Oceanic (ATW). This is levered more to the shortage of rigs and not the price of oil.

Metallurgical coal/iron/steel. This one is a bit tricky. The start of the decline came from lower coal prices in Europe. I am still a bull on this, as the world is still moving to a middle class society with concrete, steel and glass buildings. Not to mention cars and all things related to minerals. But this could be in for a deeper correction that we expect. For this area, I like iron and metalurgical coal miner, Cleveland Cliffs (CLF). Mechel (MTL) still remains my favorite Russian integrated steel producer, and Arch Coal (ACI), Alpha Natural Resources (ANR) and Massey Energy (MEE) for more metallurgical coal.

Now, I might have mentioned a lot of coal stocks, but they are not my favorite sectors at this point. I just happen to like a basket of stocks in this sector. What's important, is to understand that these stocks aren't going straight down.

Nothing goes straight up, or down, so use wide scales. I prefer the 50 (we are there today in a lot of names), 150 and 250 day exponential moving averages as starting points. Or perhaps the fibonacci retracement levels. But a key point is to make sure you have cash at all times.

Start small, and build a position. Expect significantly lower prices, and sell some into bounces along the way. Understand that you are going to take some pain along the way. Just accept it.

Disclaimer: Long MOS, POT, RIG, CLF, MTL, ACI, MEE, and hedged with a lot of SMN.

Comments

[investor88]

Now this is a sensible and good article, practical, insightful and realistic.

[dougnhi]

typical pump story on all the overblown bubble commodity stocks. The correction is well overdue, and the typical "hold your position" advice doesn't serve the community well. These particular stocks (which the author is long in) can fall MUCH FURTHER! Just look at the P&Fs for any of them! Ignore his advice and watch out below! In a global recession and credit crunch, most of these will see dramatically reduced demand.

[mcadoo3312]

Agreed. Very good point on RIG and ATW being tied to rig demand, not oil.

[David White]

POT is at a very strong technical support point (or at least it hit it overnight) -- 208-209. If the market tanks further (by a good margin) it can go further down. However, from a purely technical standpoint, it should rise from here as the good fundamentals behind it are still in place. The worldwide demand for food is increasing, especially with the increased affluence of China and India. The last 2 times it hit its 50 day moving average, it bounced upward strongly within a two week period. Of course, that it no guarantee it will do so this time. The market may continue downward. However, I am not sure the fundamentals are there for it to do so. Oil now seems to be the biggest problem. We need to start conserving more as a nation to keep this factor from running us into a deep recession. We also need to start producing more oil.

[David White]

Let's jsut hope the 1250 level support on the S&P500 holds. It is close to that now. With the light volume today, the market might go down??

[barnburner]

Cash is about the best idea Mr. Fong mentioned in his article.

[David White]

The ISM numbers were worse than predicted. However, I think everyone was expecting this to be true after the ADP numbers came out yesterday. This shoudl really be no news today. We just have to see if the market holds at support. I think the down move is already baked in to a large extent for this news.

[David White]

The other Ag stocks seem to be in a simialr position. So far the S&P500 is holding. The VIX looks like it is turning downward. If the S&P500 can continue to hold (rise) the Ag stocks will likely follow it upward.

[David White]

Also the Dollar has been going up today on news that might normally make it go the other way. The ECB hiked its interest rate to 4.25% (+.25 points). The ISM report was negative. I think this positive action by the dollar is a very positive sign for the market. It shoudl also help oil prices, if this is a "real" dollar uptrend start.

[David White]

I interpret this dollar rally to mean that the global markets have more faith that the U.S. Fed is taking the more appropriate action to engender stronger U.S. economic growth.

[Peter Leung]

Great article once again. While I don't necessarily agree that AG is all that hyped up anymore, I do appreciate the picks he comes up with.

[blink0404]

As the market continues to go down, materials, which used to be a safe haven, now looks like it may be subject to a down trend. Here's a pretty good podcast that discusses what to during this down market and what's going on with coal, steel, bulk shipping, and agriculture.

the main idea is that individual investors dont have to act like institutional investors and this market and may be better holding cash than trying to beat the market.
www.greenfaucet.com/sh...

[nevket240]

Q"I interpret this dollar rally to mean that the global markets have more faith that the U.S. Fed is taking the more appropriate action to engender stronger U.S. economic growth. "UnQ

Good grief!!! Going into a long weekend with a raft of shitty news and people honestly believe the "rally" wasn't more manipulation of the market for political purposes?? HELLOOOOOOO.
No wonder the US is doomed.
regards.

[Bob Gary]

Great piece. Another tough day for commodities. Kurt Kasun has some good pieces on greenfaucet about how to navigate the space. Next week should see some stabilizing in the sector. At least the de-coupling between commodity prices and commodity stocks should end.

[ICouldBeWrong]

You might like to consider investing directly in commodities (via futures) rather than commodity stocks.

Long commodities. Short equities. Long Yen.

[schminkie]

last i read the supplies of thermal coal were hitting rock bottom at u.s. electric power plants and the shortage of metallurgical coal for coke/steel production gave producers a strangle hold on the steel industry, sky high prices. demand is well beyond supply to a point that a 'slow down' in china would barely put a dent in the situation. minus export, the demand for fundamental substances for building
infrastructure alone will support the coal industry, iron ore industry, etc. the amelioration of weather related damage in australia and the end of ore negotiations between bhp billiton and chinese steel mills will not lessen but instead will bake in and stabilize the doubled [+/-] prices. the long term power disaster in south africa is awful yet does not deter investment by arcelor mittal et al.

for the short run i suppose dips spurts and corrections are important plays in commodities. but in the long, run even the so-called slow downs and price barriers and macro- economic concerns will bow to the strength of what is essentially an industrial revolution; an economic movement of historic [literally] proportions.

much chatter about lower exports from china. more important is the lower exports of these commodities from the likes of indonesia, vietnam and india. given the choice between selling them at record profits or retaining them [gov't policy, tariffs] to use for their own infrastructures, it seems for now that local investment rules.

personally i like dry bulk shipping, brazilian iron/steel industries and met coal miners. i am fairly giddy at the prospect of taking substantial gains and buying back in way lower.

f.y.i: in my readings [foreign press, trade papers, gov't positions and studies] i find that fear of an american slow down etc. is often lip service and that more than one of these source expresses no fear whatsoever. i think there is schadenfreude at work to wit, many nations are happy to delink from the u.s. and it's tsuris as much as is possible.