Exchange traded funds tracking the basic materials sector often broadcast strength or weakness in the broader market because the highly cyclical industry is sensitive to the global economy, energy prices and emerging markets.
Materials ETFs have been lagging the S&P 500 the past year and have often faltered before the overall market.
Top holdings include chemical companies such as Dow Chemical (NYSE: DOW) and miners such as Freeport-McMoRan (NYSE: FCX).
The performance of materials sector ETFs can foreshadow softness in the global economy. For example, basic materials were exhibiting relative weakness versus the S&P 500 in early 2011 before the August waterfall sell-off.
“The materials and energy sectors of the S&P 500 have performed the worst since the broad market declines began in early May. Global economic slowdowns have occurred in many important markets, especially in the Eurozone and in BRIC countries,” writes Dave Fry at ETF Digest.
“It follows when you track certain basic commodity markets, including copper and crude oil strength or weakness, there will spill over to the materials sector. Weakness in these markets combined with stock market weakness is a recipe for a decline in the overall sector,” he said.
Along with energy and utilities, the materials ETFs are the worst sector performers in 2012.
“In the near term, this sector likely will be challenged by tepid recoveries in developed markets and slowing growth in China. But in the medium term, we expect the outlook for the materials sector to improve as the global economy improves combined with stronger growth from emerging markets,” Morningstar analyst Robert Goldsborough wrote in a report on IYM.
“Developing economies need commodities like industrial metals, steel, and chemicals for new buildings and infrastructure. In addition, anticipated increases in consumption for consumer goods, like automobiles and consumer electronics, also will drive demand for a variety of materials,” he said.
The chart below shows the relative performance of a materials ETF and the S&P 500. When the chart is falling, materials are underperforming the S&P 500.