Buy, Sell or Hold: Capitalize on Resurgent Commodities Prices with the Market Vectors Steel (NYSE: SLX)

With the market very near critical support levels, critical earnings reports on the docket, and inflation and employment data set for release, it was more prudent last week to keep the powder dry. But the market surprised to the upside, as key companies reported better than expectations.

Participation in fixed income issuance and trading, gave investment banks buoyancy.  But JP Morgan Chase & Co. (NYSE: JPM) actually confirmed two of the three fears that I outlined last Monday:  A bleak commercial real estate outlook – which will have little consequence for the bank given its limited exposure in this area – and a spike in credit card delinquencies.

The third fear I had, the rise in residential foreclosures, was confirmed by a report from RealtyTrac that said foreclosure filings in the United States jumped to a record 1.9 million in the first half of 2009.

Of course, there are some indications that the consumer problem loan and unemployment metrics might be in the process of peaking.

Headline unemployment numbers were much better than expected because of the methodology used for seasonal adjustment, which anticipates maintenance-related layoffs at automakers during this time of the year.  The difference this year is that the layoffs occurred much earlier as General Motors Corp. (NYSE: GRM) and Chrysler Group LLC restructured.  Therefore, the regular seasonal adjustment performed on the number over-corrected for these layoffs that occur at this time.

If unemployment is peaking, we may see end to the consumer malaise in the months ahead.

Still, the earnings season has just begun. The technology sector has also seen positive surprises, not just in bottom lines but sales growth in some cases – especially semiconductors.  This is very important, since semiconductors typically lead the tech up-cycle.  In this sector, the market has correctly anticipated the good news and rallied.

So, even though the U.S. Federal Reserve has assured the market, and the world, that it will bring an appropriate end to quantitative easing, there remains a possibility that the reduction in monetary stimuli won’t come in time to prevent inflation. Both the Producer Price Index (PPI) and the Consumer Price Index (CPI) came in higher than expected last week, with the main areas of price increases focused on food, energy and at the beginning of the production chain.

The June headline CPI rose 0.7%, while core CPI, which excludes food and energy, rose 0.2%.  This was preceded by a hot PPI, which increased 1.8% from May, the largest monthly increase since November 2007. Once more, the main culprits were food and energy, since core PPI, which excludes these two sectors, was up 0.5% for the month. Still, on a year-over-year basis, core producer prices of finished goods remain 3.4% above those of the previous year.

Hence, the general strength in the price of oil and energy, some agricultural products and industrial metals, along with a pick up in retail sales and a possible peaking of unemployment offers some hope that the “reflation” policies of the Fed and the U.S. Treasury are having an impact.

This is the typical behavior of inflation in the early part of the cycle.  What we do not know is what proportion of these price increases is the result of China’s extraordinary accumulation of oil, copper, iron ore and other resources, and how much is attributable to the standard surge in prices at the beginning of a recovery.

In any case, I expect continued firmness in these prices in the second half of the year.  After the initial profit-taking and consolidation takes place, the weakness in the U.S. dollar, the expected acceleration in the deployment of the fiscal stimulus, and the traditional seasonal strength of the economy– spurred by back to school and later by the Christmas season – will provide us with as much as 2% growth in gross domestic product (GDP) in the third quarter of and a similar, or maybe even higher number, in the fourth quarter.

That’s why we are going to concentrate on the sector that I expect will gain the most momentum this summer: Public construction.

The global deployment of fiscal stimulus should translate into an unexpected surge in demand for steel.  China’s stimulus is running at full steam, with that economy posting 7.9% growth in GDP in the second quarter – up from 6.1% in the first three months of the year.

Remember that China needs its economy to grow by at least 8% in order to employ the 18 million workers that join their labor force each year.  With deflation still affecting some sectors of the economy, I do not expect Beijing to be quick in removing any stimulus and to only start doing so early next year. China’s public and private construction will remain robust and expand further, providing support for global steel prices.

Since this is a sector call, rather than a company call, and I want to minimize the exposure to a possible mishap in execution from any one company, I recommend buying Market Vectors Steel (NYSE: SLX) exchange traded fund (ETF).

The ETF surged more than 135 last week and is still well below recent highs. It seems to be ready to break resistance and will show very strong price appreciation should this occur.

Recommendation:  Average into the Market Vectors Steel (NYSE: SLX) ETF over the next month (**).

(**) - Special Note of Disclosure: Horacio Marquez holds no interest in the Market Vectors Steel ETF.

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