Unless they were shorting stocks, most investors sprinted away from commodity-related investments in 2015. And for good reason: the S&P GSCI Total Return Index, the leading commodities index, suffered a 32.9% loss in 2015, its fourth-biggest shortfall since 1970 and its first straight three-year deficit, wiping out 55.6% over that period. But don’t let that influence your opinion on the S&P 500 materials just yet, despite its 10.4% hit in 2015. There is more to the index than just commodities.
Business Cycle Basics
The materials sector is considered cyclical because demand ebbs and flows with the business cycle. The sector is broad, including industries such as aluminum, commodity chemicals, construction materials, gold, specialty chemicals, steel, paper packaging, and fertilizers.
Sam Stovall, managing director at S&P Capital IQ, describes it this way: "The things you pull out of the ground and use to build things or grow things." The sector is chemicals-heavy, with "specialty chemicals" and "commodity chemicals" industries comprising some 60%. Investors may want to consider the mantra, "As goes chemicals, so goes materials," says Stovall.
Two historic hulks in U.S. business, Dow Chemical Co. (DOW) and DuPont Co. (DD), made headlines with a pact to merge and form DowDuPont. That’s the first step in a multi-year plan to split into three companies in agriculture, commodity chemicals, and specialty products. "They realized they have value that is not being fully exploited," Stovall says.
And the Winner Is …
Sometimes when you dig deep into a sector you might find something unexpected and surprising. Although the materials sector overall took a hit in 2015, the construction materials sub-industry tucked inside this group closed out the year with a whopping 35% gain, according to S&P data. Two companies included in this group are Martin Marietta Materials, Inc. (MLM) and Vulcan Materials Co. (VMC), both of which provide materials for residential and non-residential construction. That’s good news in light of the macro fundamental drivers boosting the construction-materials segment.
"The unemployment rate is coming down, and wage growth is expected to rise,” Stovall notes. “Because housing prices continue to improve and investors believe that banks will be more willing to make loans, we are seeing an improvement in demand for companies that provide construction materials."
Don’t Worry, Be Happy
Investors exacted a heavy toll on the materials group overall last year. Don’t worry, Stovall says, that decline could be a classic case of "technical versus fundamentals or price trends versus earnings growth expectations" because "their prices have fallen faster than their earnings."
Moreover, easier comparisons make for a positive earnings outlook ahead. This year the materials group is forecast for a 16% rise in earnings versus a 7.5% rise in the S&P 500, Stovall notes.
But investors may still want to tread carefully in this arena, because international demand is still in question. With the economic cloud hanging over China and uncertain emerging market demand, "One would have to be a contrarian to say now is the time to back up the truck and load up on positions in the materials sector," says Stovall.