SET Monthly Issue April 2017

| April 4, 2017

Back To The Basic Materials

The economic laws of supply and demand never stray far from the world’s mines.

When demand for basic materials slides, and when prices start to fall, production is cut to try and prop prices back up.

It sounds simple, but the trick for the mining or basic materials company is to read the market properly so it doesn’t put production cuts in place based on what may be a false signal.

(Or vice versa.  This can be a slippery slope and the impact on operating expenses is huge.)

When demand is revived, prices hold and production increases.  If demand continues to grow, both production and prices go up.

Mining and producing basic materials is a basic business, and its simplicity is one of the reasons why we’re attracted to it.  The other reason… the lofty prices of so many stock market sectors right now.  Basic materials companies have been through tough times.

This is why we’ve been keeping an eye on developments, and why this month’s recommendation is The SPDR S&P Metals & Mining ETF (XME). 


Base metal production was slashed in 2015.  Prices went up in 2016.  Now, we’re starting to see supply increases as well.  According to the Bloomberg intelligence analysts, the largest supply increases will be for zinc and the smallest supply growth will be for copper.

With so many different base metals and basic materials, where supply and demand can move in different directions, it takes highly specialized knowledge to identify the most promising opportunities.

Something else to factor in is the value of the Chinese yuan.  When the yuan loses value compared to the U.S. dollar, China pays more for base metals.  The Chinese may choose to cut back on production rather than spend more money for raw materials.  All this adds up to multiple moving parts for investors to deal with.

A good solution is to diversify, which is what this ETF takes care of for us.


The ETF tracks an index that is equally weighted between U.S. metals and mining companies.   But not all the mining companies produce metal.  For example, some companies produce coal.

If you are looking for a pure play, and you think the coal mining business belongs in the energy sector, XME is not a good choice.  But we like this degree of diversification.  We see the lack of a strong concentration in integrated mining firms as a plus.  Exposure to coal isn’t the kiss of death if you’re an investor.

After all, coal produces 44% of America’s electricity right now.  While it’s reasonable to expect this number to trend down, coal fired utility plants aren’t vanishing anytime soon.  The transition to cleaner energy production will take time.


The performance of this ETF is primarily driven by two products… aluminum and steel.  Their prices are the bellwethers for the ETF.


In 2016, aluminum prices shot up 16%.

Are we too late?  Is the party over?  We don’t think so.

The three leading customers for aluminum are the global automotive, construction, and packaging industries.

Five factors will come into play with these global commodity prices.  White House economic policies, supply and demand economics, interest rates, energy prices, and raw materials prices.

The most significant factor is U.S. economic policy.  If the anticipated major investment in domestic infrastructure takes place, aluminum demand could increase dramatically.

If the value of the U.S. dollar grows too strong, or if tariffs come into play, big aluminum companies like Alcoa could run into some trouble.  That’s because of business Alcoa does in Europe, which could slow down.  But a strong dollar isn’t all bad, because Alcoa produces aluminum abroad, and can use the strong dollar to its benefit to offset production expense.

The economics of supply and demand won’t just be set by White House policy makers.  They will be heavily influenced by China, the world’s #1 customer for aluminum.

It’s been difficult to gauge the economic direction of China.  But the possible eruption of a trade dispute between China and the U.S. could put a costly dent in U.S. aluminum exports.

Alcoa (AA) and Rio Tinto (ADR: RIO) are the world’s two major aluminum producers.  Alcoa has been forecasting demand for aluminum to edge up 4% this year.

Alcoa is actually a new stock following a corporate spinoff last year.  Alcoa keeps the name of the well-known aluminum company that’s been around since 1888.  A different company, Arconic (ARNC), markets expensive engineered aluminum and titanium alloys.

Look at how the new Alcoa has done since the breakup…


The steel industry has taken a hit because of less business from China.  The World Steel Association expects this to continue.  It forecasts demand for steel in China will be down 2% in 2017 compared to 2016, which was also a down year.

This has put pressure on prices, and has made it difficult for producers to grow profits.  Conditions have been volatile, steel prices have been up and down, and you see it reflected in the stock price of one of the ETF’s holdings, U.S. Steel…

U.S. Steel


Mid-February the ETF reached a high of $35.21.  Since then, XME is giving up ground…

SPDR S&P Metals & Mining ETF

We are always aware of the dangers of trying to “catch a falling knife” but we believe that this is a good time to invest in XME.  We are not concerned about a pullback to levels we saw at the beginning of 2016.


The ETF’s volume runs high.  The index it tracks is rebalanced once a year.  Total assets are $891 million, the expense ratio is .35%, and there is a modest yield of .95%.

88% of the companies the ETF tracks are in the basic materials business, 7% are in industrials, and 5% are in energy.

The top five holdings of this ETF constantly change.  That’s because of never-ending commodity pricing shifts which impact stock prices.  On a typical day, there may be 20 different stocks, each of which represents 4% of the index being tracked.

Rarely have we seen a single stock represent more than 5% of the ETF’s holdings.

We aren’t looking at this ETF to invest in gold, silver, or precious metals.  It’s the less glamorous iron ore, steel, and aluminum we value.  We’re all about capturing the value of basic materials.

But let’s not overlook the fact that gold plays a role in overall performance.

On a given day, a company such as Royal Gold Inc. (RGLD) will appear as a top holding.  But precious metals aren’t a big factor.  Basic materials drive the SPDR S&P Metals & Mining ETF bus.


Daily moves in commodity prices constantly reorder the rankings… what you see tomorrow may be a much different lineup…

Company Name Sector % Weight
ALCOA CORP. Aluminum 4.88%
U.S. STEEL CORP. Steel 4.76%


Alcoa produces and sells bauxite, aluminum, and aluminum products.  These include

aluminum cast products and sheets to produce cans for foods and beverages.  It also generates and sells renewable energy.


United States Steel Corporation operates in three segments:  Tubular Products, Flat-Rolled Products, and a European unit.


Cliffs Natural Resources Inc. is a mining and natural resources company that produces and supplies iron ore from four mines in Michigan and Minnesota.  It also operates a mining complex in Western Australia.


Newmont Mining focuses on gold, silver, and copper.  It has gold reserves of 68.5 million ounces and owns 23,000 square miles of land.


 Allegheny produces and markets specialty materials and components.  Like U.S. Steel, it is in the business of flat-rolled products, but it also sells high performance materials and components such as titanium, titanium-based alloys, ingots, billets, bars, rods, wires, shapes and rectangles, seamless tubes, precision forgings, castings, components, and machined parts.


This is not a core holding, and based on what we see with prices over the next few quarters, it may not be a long-term holding.  But we see an opportunity for growth and we want to be prepared to capture what may be a significant upward move.

Since 2011, while the broader market has kept moving higher, basic materials stocks have floundered.  We’ve recently seen a rebound, which is encouraging.  But as you see from the chart, prices are nowhere near where they were just six years ago, let alone prior to the 2008 meltdown.

Basic materials prices will ebb and flow like any commodity, and will reflect supply and demand.  Be prepared for fluctuations.

Trade Alert

Buy: The SPDR S&P Metals & Mining ETF (XME) to $31.50

Recent Price:  $30.94

Price Target: $37.00

Stop Loss:  $29.00



Consumer Discretionary XLY +10.29%
Consumer Staples XLP +1.62%
Energy XLE +14.28%
Financials XLF +28.55%
Health Care XLV +8.56%
Industrials XLI +16.49%
Materials XLB +15.41%
Real Estate XLRE -1.82%
Technology XLK +19.15%
Utilities XLU +2.99%



 This is a good time to take some money off the table and sell two energy ETFs.

. . . . First Trust ISE-Revere Natural Gas Index Fund (FCG) – SELL

We’re going to take a modest loss and liquidate our position.  In retrospect, selling at highs reached late last year for a 7% gain would have been prudent, but our long-term outlook prompted us to hold.  Now, we’re increasingly concerned with natural gas prices as warmer weather arrives, and supply appears to be outstripping demand.

. . . . PowerShares S&P SmallCap Energy ETF (PSCE) – SELL

It’s time to take 15% in profits and move along.  This ETF has performed well, and we are selling below recent highs.  But profits are profits and we’ll gladly put them into our cash account and be prepared for future opportunities.

The rest of our portfolio…

. . . . iShares MSCI Switzerland Capped ETF (EWL) – HOLD

The ETF has edged up above our buy up to price.  Monitor and buy on any dips.

. . . . SPDR S&P Pharmaceuticals ETF (XPH) – HOLD

The pharma stocks have regained some lost ground, but have not broken through previous highs following our investment.  As long as uncertainties surround U.S. health care policy, we’ll see our ETF buffeted by ups and downs.  We’re in for the long haul.

. . . . Vanguard REIT ETF (VNQ) – HOLD

The REITs have recovered well from recent lows.  We’re happy to hold, and do not expect any difficulties with the real estate valuations.

The dividend yield is a solid 4.66%.

. . . . PowerShares Dividend Achievers ETF (PFM) – HOLD

PFM is trading in a narrow range, reflective of the broader markets.  Current yield is 4.06%. 

. . . . First Trust ISE Global Engineering & Construction Index Fund (FLM) – HOLD

Not unlike our pharmaceutical ETF, performance of the Global Engineering & Construction Index Fund ETF is heavily impacted by federal government policy.  We continue to expect the ETF price to rise further, and build on strong gains, as a more precise picture of infrastructure spending develops.

. . . . Vanguard High Dividend Yield ETF (VYM) – HOLD

No major moves or significant news.  Current yield remains steady at is 2.81%.

. . . . Utilities Select Sector SPD (XLU) – HOLD

No changes.  Continue to hold.  This ETF remains a core position.

Portfolio Changes

  • Buy SPDR S&P Metals & Mining ETF (XME)
  • Sell First Trust ISE-Revere Natural Gas Index Fund (FCG)
  • Sell PowerShares S&P SmallCap Energy ETF (PSCE)

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