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  • Commodity stocks were top performers earlier this year when inflation was accelerating.
  • The group is underperforming since May because of worry over declining global GDP.
  • Energy stocks do well in the late-stage of the business cycle, but returns slip in the recessionary-stage of the cycle.
  • The pullback may offer a short term trading opportunity, but other sectors should be the primary focus.

Commodities were the shining beacon in the first five months of this year when global economies were humming, and inflation was accelerating. However, they’ve been poor performers lately because global rate hikes are slowing economic activity.

Since the May 20th low on the S&P 500, the Invesco DB Commodity ETF  (DBC)  and SPDR Select Energy ETF  (XLE)  are down 10% and 9%, respectively. They have underperformed since June 17th's S&P 500 low too. The commodity ETF is down 12%, while the energy ETF is up only 1%.  

Does it make sense to buy them now that they've fallen?

A tough row to hoe

Historically, energy and commodity groups do well in the late stage of the business cycle when robust economic growth exceeds supply, pushing prices higher. That leadership disappears, however, when the cycle shifts to the recessionary stage because inflation-busting rate hikes crimp economic demand, and pre-recessionary investments increase supply.


I wrote in "Is it Game-Over for Energy Stocks" on June 14, "If the XLE closes below its 50-day moving average, make sure you're using trailing stop losses to protect your portfolio. You don't want to turn a winner into a loser. Remember, energy stocks are called "cyclicals" for a reason. At some point, the music will stop, and you won't want to be without a chair when it happens."

Then, I wrote in “Business Cycle: Is A Sector Shift Underway?” on June 23, “the XLE broke through the 50-DMA, and now, it's challenging support at the 200-DMA. Of course, the XLE could make a stand near its 200-DMA, which may allow you to take some top stocks here for a bounce, but even more than on the 14th, these are rentals, and you need to use trailing stops for protection. The broader commodities market could be riskier. The DBC broke below its 50-DMA yesterday, and unlike energy, which is only about 5% above its 200-DMA, the DBC would have to drop 13% before it finds its footing at the 200-DMA…Again, if you're long commodities, protect yourself by reducing exposure and using stop losses, so you don't get trapped.”

Has my opinion changed? Nope.

Cyclicals trade cyclically. There are times when they do very well and times when they do poorly. As a result, you should invest in them opportunistically, especially when global demand is shrinking because of rate hikes.

That said, there could be an “opportunistic” trade now with the XLE testing its 200-day moving average again, but first, let’s talk a bit more about the cyclical headwind.

In “The Oil Bulls Aren't as Bullish as They Were as Demand Withers,” Real Money Pro’s Maleeha Bengali writes: 

“Commodities are about demand as much as they are about supply. The latter is easy to forecast to an extent as production projects take time to plan and so the lead time is well-known. The former is the Achilles' heel of many analysts purely because they assume demand is a constant and only keeps growing and never falls.”

Demand extrapolation is pretty standard in any sector when animal spirits kick in. So it’s certainly not the first time we’ve seen commodity bulls get overly optimistic about never-ending demand. For example, Real Money Pro’s Carley Garner reminded us on my Twitter Spaces last month that a similar scenario played out in 2008, the last time crude prices skyrocketed to similar levels. For perspective, after rallying to $147 per barrel from $50 between January and June 2008, West Texas Crude fell to $32 per barrel by early 2009.

Back to Bengali:

“Industries, consumers, and businesses all over are suffering from the monster economy the Fed has created and demand has been falling. At a time when demand for all goods is falling, supply has been stable to rising, which means prices need to come down. This is the case in oil, too, as supply deficits once penciled in and euphoric assumptions of the world running out of oil are now being ratcheted back as the second-half inventory balance looks a lot more normal. Demand is never a constant and the sell side analyst, just like the Fed, really just pencils in what has happened, never able to take a view of what will or could happen. Therein is the problem as it really does not help the investor to invest in a timely manner, as these same clients are now nursing wounds of negative 40% after being sucked in by the bullish analyst calls.”

Overall, it pays to overweight and lengthen time horizons on commodities when expanding GDP causes inflation to accelerate. However, when rates are rising, GDP is declining, and inflation is slowing, it’s best to underweight and shorten the time horizons on commodities. For this reason, I’ve reduced my energy weight substantially over the past couple of months.

So, is there an opportunity to “rent energy” stocks?

There’s always a bull and bear tug of war, and it takes for folks to shift long-held convictions so stocks don’t rise or fall in a straight line. For this reason, active investors may consider picking up stocks that are selling off when they reach price support levels.

In “A Little Late to the Tech Party?Top Stocks technician Helene Meisler updates investors on her thoughts regarding energy stocks.

As a refresher, she said energy was over-loved and over-owned in May. In June, she put a $70 target on the XLE and suggested it bounces once it gets there, which it did. What does she think now? She writes:

“Since I have been back from vacation, I have consistently said I thought we wanted to see energy stocks come back down. In XLE’s case, I once again had $70 or so in mind. In fact, you can see there is a gap to fill around $69, which would be a good spot to have another look to buy.”


Meisler’s technical take is the XLE finds footing in the $69 to $70 area, which coincides with its 200-day moving average support, but if you’re an individual stock investor, she also notes that buying Chevron  (CVX)  could make sense.

She writes, “Chevron is just about to fill that gap. I’d prefer if it wait until next week to do so because tomorrow is the Employment number, which tends to exacerbate moves. But I would buy some CVX on the gap-fill.” On August 3, she also wrote, “For those who keep asking about energy stocks, should Chevron fill that gap in the $150 area I’d be a buyer.”


The Smart Play

The ‘easy money’ business cycle trade could be over for commodities, so the focus should primarily be on recessionary-stage groups like healthcare, consumer staples, and utilities, all of which have posted solid returns since June’s low.

For example, the SPDR Healthcare Select ETF  (XLV)  and SPDR Biotech ETF  (XBI)  are up 10% and 32%, respectively, while the SPDR Consumer Staples ETF  (XLP)  and Utilities Select ETF  (XLU)  are up 8% and 14%, respectively, since then.

Nevertheless, suppose you’re an active investor or want to maintain energy exposure in line with the S&P 500’s energy weighting (~4.4% as of July 31). In that case, Meisler thinks you can carve some profit long in the XLE or Chevron by buying at support. If you pick up shares in either of them for a rental, consider running a stop loss below their mid-July lows.

  • Commodity stocks were top performers earlier this year when inflation was accelerating.
  • The group is underperforming since May because of worry over declining global GDP.
  • Energy stocks do well in the late-stage of the business cycle, but returns slip in the recessionary-stage of the cycle.
  • The pullback may offer a short term trading opportunity, but other sectors should be the primary focus.
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