About 10 years ago, when I moved from being strictly a commodity supply, demand, and price forecaster into the weird, wild world of equity analysis, I wasn’t quite sure what to expect. On the one hand, the job was essentially the same – to determine either near-term or long-term directionality, depending on the focus. But on the other hand, now I had to take risk into account.
Because what was at stake was no longer just a series of numbers on a piece of paper – a series that, mind you, I could adjust in a month if reality did not comply with my modeling.
Instead, my parent company was making recommendations to readers based on my analysis, which added a fiduciary duty that does not sit particularly well with the “agnostic” approach taken by most market analysts.
Fortunately for me, I was just starting to write a commodity-focused newsletter with acclaimed natural resources investor Rick Rule, then of Sprott Global. And in our first real conversation as colleagues rather than a client, he fed me a version of his oft-repeated line, “The natural resources space is inherently cyclical. And in these markets, either you are a contrarian or you will be a victim.”
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Though I can’t say Rick’s quip about being a contrarian is particularly original – personally, I prefer Warren Buffett’s, “Be fearful when others are greedy, and be greedy when others are fearful,” – it is particularly prescient with regard to its application.
After all, at its core, being a contrarian is the soul of the Cabot Turnaround Letter. And to that end, a pronounced focus on new executive leadership, activist campaigns, bankruptcies, spinoffs, and deals have been the primary feeding grounds for ideas throughout its existence.
But in this longtime commodities analyst’s opinion, the easiest turnaround opportunities come from simply tracking the business cycle.
Cyclicals Do Cyclical Things
Whether we’re talking about energy, basic materials, industrials, financials – no matter the sector – each industry has its own inherent ups and downs. Some follow seasonal patterns, while others are more periodic. Some are sensitive to macroeconomic factors such as interest rate and currency fluctuations, while others are more tethered to the physical world.
And while there are a number of valid approaches to analyzing those sectors, many require expensive or obscure datasets to do the deep work properly, which is just not feasible for most generalist investors. But when you think about it a little, the output of any supply/demand/cost analysis is price. And as it turns out, that is the one dataset to which we all have access.
The approach I take to price analysis is pretty simple. First, we need to know how a price is performing relative to itself, or what we call absolute momentum. To measure that, I tend to use Bollinger Bands, which represent two standard deviations (2SD for short) above and below a median price, and the Relative Strength Index (RSI for short), which quantifies short momentum in a range from 0-100.
Just for simplicity’s sake, let’s look at the Invesco QQQ Trust Series 1 (QQQ)
Source: Tradingview
Here, we can see that QQQ is currently trading ABOVE its upper 2SD Bollinger Band, and the RSI (on the bottom) is at 52-week highs around 80. While overbought conditions like these can persist for some time – as they did from November of last year through April – usually this is a good spot to take a little profit off the table.
The second aspect to the analysis is a price’s performance relative to others, or what we call relative momentum. To illustrate this, let’s examine the ratio of the Invesco QQQ Trust Series 1 (QQQ) to the S&P 500 (SPY):
Source: Tradingview
For comparisons like this, a rising slope and RSI means that QQQ is outperforming SPY, whereas a falling slope means it’s underperforming. Given this ratio is also at all-time highs and RSI is at cycle peaks, this is likely confirming that it’s not a bad time to take some chips off the table.
Now let’s look at examples on the other end of the spectrum. Most commodities have been flagging of late, which is frankly pretty typical for this time of year. Temperatures are mild and vacations have yet to really start, so demand for things like power and gasoline has yet to ramp back up. Similarly, the steel sector has finished restocking for a few months, and prices for raw materials – such as iron ore, pictured below – are at cycle lows.
Source: Tradingview
But, per the green arrows I drew on the chart, every year there is a cyclical upturn in the market starting around the beginning of fall in September, give or take a few weeks. While there’s a chance it might not be as robust this year as in years past, rest assured, automakers will come into the market to buy steel, and steelmakers will in turn have to come back into the market to buy iron ore and replenish their stockpiles.
Now, if we were to look at the major iron ore suppliers, such as VALE depicted below, it should come as no surprise that we’ll see the exact same seasonal patterns.
Source: Tradingview
Just like the underlying iron ore price, every fall VALE tends to get a boost from restocking season, resulting in short-term gains of over 100% in 2021-22, 75% in 2022-23, and roughly 30% in 2023-24. And while one would need to be patient here – three months is an eternity to hold commodity stocks – both the season and the metrics (Bollinger Bands and RSI both at 52-week lows) tell us the cycle is not far from inflecting upward.
Ultimately, it’s the push and pull of these types of pricing dynamics that fuel investment banks’ and hedge funds’ periodic rotation from one sector or factor exposure to another. And although it takes a good long while to figure out the interplay of each, the basic sector and factor ETFs listed below are a good place to start learning the cycles.
Source: Cabot Wealth
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