BASIC MATERIALS WEIGHED DOWN BY CHEMICALS -- THEY'RE ALSO CYCLICAL IN NATURE -- GOLD IS OVERBOUGHT BUT STILL BULLISH -- HOW TO BUY RISING RATES

BASIC MATERIALS ETF IS UNDERACHIEVING ... With all the recent talk about basic material prices moving up, a lot of readers have asked if this a good time to put money into the Materials Select Sector SPDR. I don't think so. Although it may seem counter-intuitive, the XLB has done very poorly this year in the face of rising commodity prices. That poor performance can be seen in Chart 1. The XLB peaked in March and is trading well below its moving average lines. It's also dangerously close to a new 52-week low. The relative strength ratio beneath the chart also peaked in the spring and is already at the lowest level since the spring of 2004. Part of the poor performance has to do with the make-up of the Materials SPDR. Most of the recent gains in the commodity sector have come in the energy and mining sectors. The XLB has no energy stocks and a small mining weighting (in copper and gold). It's heaviest weighted stocks are in the chemical, aluminum, and paper categories which have done very poorly this year. The heaviest weighting is in chemicals which have actually suffered from rising energy prices.

Chart 1

MATERIAL LAGGARDS ... Three of the worst performers in the XLB are shown below. All three have fallen to 52-week lows and, unfortunately, they also happen to be among the biggest holdings in the Exchange Traded Fund. Chemicals have an unusually heavy weighting with the two biggest holdings in Dupont (15%) and Dow Chemical (12%). Since natural gas is a big raw material used by chemical companies, they've been especially hard hit by this year's energy increases. Alcoa has a weighting of 10% while International Paper represents 6% of the XLB. Chemicals, aluminum, and paper comprise almost half of the XLB.

Chart 2

MATERIAL LEADERS ... Most of the leaders in the XLB have been in the copper and gold category including Phelps Dodge, Freeport McMoran Copper & Gold, and Newmont Mining. Phelps Dodge has been greatly helped by record highs in the price of copper as has FCX. Newmont has been helped by the recent move to an eighteen-year high by gold. Unfortunately, those three stocks comprise less than 10% of the value of the XLB. That's why in my recent writings I've been recommending gold stocks and not the XLB. There may also be an economic reason for the materials' poor performance.

Chart 3

CYCLICAL STOCKS ARE FALLING ... A lot of the stocks in the materials group are also cyclical in nature, which means that they rise and fall with the business cycle. As a result, many of them are also included in the Morgan Stanley Cyclical Index (Alcoa, Dow Chemical, International Paper, Phelps Dodge, US Steel, etc.) The chart of the CYC has also been falling since March. Its relative strength ratio peaked around the same time that the XLB did. That's the market's way of telling us that the economy is starting to weaken most likely in reaction to rising energy prices. In other words, rising energy prices have in fact been bad for most basic material stocks. That's where gold has come into play. Gold usually rises when investors lose confidence in alternative investments like bonds and stocks. In other words, gold does best when bonds and stocks are weak. There's also some evidence that petrodollars from the Mideast have been moving into bullion instead of currency markets. That's why gold has been rising faster than all global currencies and why it's been able to rise in the face of a firm dollar. And that's why gold remains my favorite market sector .

Chart 4

GOLD IS OVERBOUGHT, BUT STILL IN A BULL MARKET... My market message on Monday on rising bond yields made mention of "all the recent gold buying" as part of the reason because it suggested higher inflation. One of our readers wondered what gold rise I was referring to since gold stocks had been down for the last few days. Chart 5 shows the rise in gold that I was referring to. Since June, bullion has risen 15% to the highest level in eighteen years. Gold stocks were second only to energy stocks in relative performance over the last three months. Over the short-run, gold and gold stocks look overextended and in need of a pause. I suspect that gold could consolidate between $475 and $460 for awhile before moving up toward its next major objective at $500. Chart 6 shows the Gold & Silver (XAU) Index stalling at the top of its two-year trading range and in an overbought condition. I recently warned that some profit-taking could materialize in this area, but that an eventual upside breakout was likely. I still believe that to be the case.

Chart 5

Chart 6

HERE'S A WAY TO PLAY RISING RATES ... A number of readers have asked for a way to benefit from the strong possibility that bond yields are headed higher. One of the best ways is with the ProFunds Rising Rate Fund (RRPIX) which is shown in Chart 7 (plotted through Tuesday). That mutual fund looks remarkably similar to the 30-year T-bond yield (TYX) in Chart 8. With the TYX trading over its 200-day line for the first time in more than a year, a decisive move over its August high would be a bearish signal for bonds and bullish signal for ProFunds Rising Rates Fund. I've also been asked if rising rates were bearish for gold. The recent rise in rates has boosted the dollar which may explain some of this week's gold profit-taking. Keep in mind, however, that rising gold prices are one of the reasons that bond yields are starting to rise. The entire decade of the 1970's saw rising interest rates coincide with rising gold prices. Gold prices may pull back if bond yields break their August highs. I would view that as an opportunity to buy some gold stocks on weakness.

Chart 7

Chart 8