Basic Materials: Too Hot Too Fast

The market is now about 13-weeks (a quarter) removed from the depths of the lows hit in October. At its lowest point, the S&P 500 hit 752 and appeared to be in free fall. Thankfully, since that time stocks have enjoyed a small, late-year, bear market rally and the S&P 500 closed out 2008 a shade over 900. However, that rally appears to be running out of steam in 2009 as the S&P lost nearly five percent in the first full trading week of the year.

BasicmatsOne sector that has recently caught our attention from a valuation standpoint is the Basic Materials sector. This sector has been extremely volatile as you can see from the included graphs. The sector has actually rallied 2.7 percent in the last 13-weeks, which beats the broader S&P 500 over that timeframe by about six percent. You can see the 13-week performance of the industries within Basic Materials on the scatter chart to the right. The Metals & Mining sub-sector has been the clear winner as its 111 companies that we cover are up nearly 16% (all results are capitalization-weighted). The Energy sub-sector has been resilient despite the relentless downturn in oil and gas prices. A return of .01% is not too shabby considering the fact that crude has plunged to near five year lows. Chemicals are slightly under-performing the broader market as they are down 5.5% over the last 13-weeks.

BasicmatsWe thought it illuminating to compare the overall very good results of the Basic Materials sector over the last 13-weeks to the results of the last 26-weeks. The juxtaposition came as a shock to us, as the 26-week return for Basic Materials was an unbelievably bad -49.3%. Over 26 weeks, Energy was the worst performing of the group down 54%, while Chemicals was the “winner” down only 37.5%. (Remember that these numbers include the recent quarter’s strength in Basic Materials.)

The way we see it this can be taken one of two ways. First, that the Basic Materials sector over-corrected during the third quarter of 2008 making a rebound in the grossly over-sold sector logical during the last 13 weeks. Or secondly, the Basic Materials sector was over-inflated by the high price of oil and other commodities and needed a major correction of this kind. Accordingly, the last 13-weeks have seen Basic Materials stocks rise along with the broader market in this bear market rally. There is merit in each of these theories, and the reality is not purely one or the other.

We are skeptical of buying into a bear market rally at its top and although we like the entire sector, would prefer to wait for a pull-back before diving in, especially in Metals & Mining. Although it is easy to make a bullish argument for oil stocks over the long-term, investors may be able to get them even cheaper as global oil demand continues to plunge. With new reports coming out each day about an over-abundance of oil supply throughout the world, it may be a bit early to be buying energy stocks. As it stands right now, we are too leery of what the market has in store over the next few months to recommend buying at these prices.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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