March 1, 2010

Commodity Sector Component ETNs

(Click to enlarge the graphic).

Off their highs posted in Jul 08, commodities seem to have languished - but are there individual sector leaders, and possibly individual winners?

The four weekly line on close charts above plot (clockwise, beginning top left) four Barclays Capital iPath ETNs: Energy (JJE), Grains (JJG), Softs (JJS) and Industrial Metals (JJM). Overlaid on each chart, plotted in orange, is the iPath Commodity Index (DJP). Red vertical dashed lines denote dates of interest, while red horizontal dashed lines depict price levels for each of the four ETNs. Lastly, a Fibonacci retracement grid is drawn peak to trough on each chart.

Clearly, the fall of commodities was precipitous following the highs of Jul 08. Waning consumption, coupled with an outright bubble in crude oil, dominated the news cycle for months. Precious metals (not depicted here) became a favored play in the commodity space going forward as gold broke from a months long consolidation in Dec 08, setting new highs in Dec 09. Anyone long the precious metals market certainly prospered, while many late to the game have been modestly disappointed. Those who entered the gold rush late continue to hold their collective breath, looking for a break above previous Dec 09 highs as a sign inflation may finally be coming.

Is this position too narrow minded? The charts above suggest so. Commodities appear to have transitioned from a unilateral bet to more of a "sector rotation" mentality akin to that of long equity. Clearly there are under and over achievers. Beginning with Energy (upper left), we look at the sector internals. The Energy ETN (upper left) is composed of crude oil (45%), heating oil (11%), natural gas (32%) and unleaded gasoline (12%). This sector as a whole has not only underperformed the entire commodity index itself, it has failed to rise despite unprecedented winter conditions across much of the entire United States. Such weather conditions would have, in years past, inflated demand and in turn driven up prices. Perhaps not so this time around as there appears to be little to no appetite on a retracement basis on this chart.

Turning to Industrial Metals (lower left), things become more interesting on a sector performance basis. The complex, composed of copper (41%), aluminum (30%), nickel (15%) and zinc (14%), has certainly popped. Demand for these industrial names has been impressive, as has their recovery, since bottoming in line with the overall commodity index in Feb 09. Any rise in the total commodity complex can, in some part, be attributed to the demand for these metals. Everything in this space was up over the entire time period, and any individual sector bet here would have paid off. Additionally, competition clearly exists for raw materials, lending additional credence to the outperformance of the Industrial sector against the S&P itself (overlay XLI atop SPY for evidence).

Looking next at the Grains complex (upper right), internals forming the ETN are soybeans (40%), corn (36%) and wheat (24%). Despite forming an earlier low in Dec 08 compared to the index low of Feb 09, this sector has languished in line with commodities as a whole. The complex showed promise as recently as late Spring 09, but has since waned. Studied independently, however, each of these three markets have behaved differently; soybeans have gone up, wheat has gone down, and corn has drifted all but sideways. The sector, in turn, ultimately has not presented significant signs of recovery, and demand appears lifeless on the surface as it moves nearly in tandem with the index - yet there was opportunity. One would not know the difference studying this space merely at the sector level.

All that said, Softs (lower right) have been the big winner since the collapse in commodity prices from Jul 08 - Feb 09. Not bottoming as soon as Grains, yet leading the overall commodities space by two months, the run up was unabated for all of CY 09. Composed almost equally of sugar (34%), coffee (34%) and cotton (32%), the Softs sector has been in high demand more than any other commodity complex. Reviewing these three markets separately tells three independent stories (see SGG for sugar, JO for coffee, and BAL for cotton). Sugar soared from Jul 09 to Feb 10, but has sold off since; coffee had an initial run up into Apr 09, consolidated into Jan 10, and is selling off inline with sugar; while slightly more bullish, cotton ran up similar to coffee, but has had a strong rebound in Feb 10. Its hard to "feel" this in the chart, though, so studying sector internals is clearly necessary.

What conclusions can we draw from these charts? First, commodities can no longer be judged as an independent investment variable. There's no questioning there are now distinct winners and losers in this space, both at the sector and market internal level. As technicians, we must first break commodities into sectors, and then further break apart their internal components, to identify the best opportunities. Simply put, commodities are no longer a one-way bet. Whether long only, or long/short, simply studying commodities as an asset class will increase overall investment risk. Revisiting the energy sector, one only need look to the relative performance of natural gas (overlay UGA, GAZ, UHN and OIL atop JJE). While crude oil seems to dominate the news, unleaded gasoline has actually performed better. Alternatively, natural gas (32% of the Energy ETN) has served to hold the overall energy sector down.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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