Commodities Are Taken to the Woodshed - What's the Game Plan?

The day started out like pretty much every day in the past few weeks. The broader market acts weak, oil remains at its high, and commodities (especially coal and natural gas stocks) make new highs almost daily.

But then we come across the woodshed.

Oh yeah... that looks safe, doesn't it?

Not bloody likely.

The reality is that the commodities trade got WAY over crowded. I mentioned in my Weekly Game Plan, that it was going to be another week of defence. And more importantly, that the risks were mounting in the most loved names.

Some quotes from the weekend game plan:

"I have to say, that as much as I liked the metallurgical coal thesis 2 months ago, I must be less bullish today."
"I wouldn't be surprised that many major funds now have significant positions in these names, which are hedging out losses in other areas. This is another reason why panic and fear have not broken out. There's still a place to hide, but that place is getting crowded."
"This is more of a game of hide and seek with a bear. But everyone is hiding behind the same curtain."
But let's get to the point. What's the gameplan from here on out? First, we need to understand the anatomy of this correction. I wrote a piece earlier about that here. Back on the edge of the Abyss

Another important consideration, is that we need to understand how the market views this correction. Yes, this is the "global growth is dead" battle cry, and since virtually everything is now somehow connected to this thesis, this has the potential to be one ugly correction. And one that is not a "V" bottom.

If we operate under this assumption, we need to realize that the stock market is an expectations game.

What happens tomorrow, next week, or even next month, is not going to depend on whether we get a global recession or not. What does matter is expectations, and that is what we need to be on the look out for. A bottom will occur in commodities when the market has fully discounted a global recession, regardless if it actually happens. So forget about if it actually happens or not. Even if it does, but expectations suggest we don't, we will get a rally.

So what's the game plan?

Again, it's Defence. But this time, we are going to defend the best of breed in the themes and companies we have the most conviction in. Most of the time, I think having the conviction is the most valuable part of fundamental analysis. So circle the wagons around the companies you have the most conviction in.

By far, my favorite theme still surrounds agriculture. A growing middle class in Asia, and to keep civil rioting at a minimum, food ample food will be required. My favorite names are the ones I've been behind for a long time. Agrium (AGU), Mosaic (MOS) and Potash (POT).

Next is deep water drilling. This "global recession" is being partly sparked by oil fears. That's why oil (the commodity) still has not faltered. Stick with Transocean (RIG) and Atwood Oceanic (ATW). This is levered more to the shortage of rigs and not the price of oil.

Metallurgical coal/iron/steel. This one is a bit tricky. The start of the decline came from lower coal prices in Europe. I am still a bull on this, as the world is still moving to a middle class society with concrete, steel and glass buildings. Not to mention cars and all things related to minerals. But this could be in for a deeper correction that we expect. For this area, I like iron and metalurgical coal miner, Cleveland Cliffs (CLF). Mechel (MTL) still remains my favorite Russian integrated steel producer, and Arch Coal (ACI), Alpha Natural Resources (ANR) and Massey Energy (MEE) for more metallurgical coal.

Now, I might have mentioned a lot of coal stocks, but they are not my favorite sectors at this point. I just happen to like a basket of stocks in this sector. What's important, is to understand that these stocks aren't going straight down.

Nothing goes straight up, or down, so use wide scales. I prefer the 50 (we are there today in a lot of names), 150 and 250 day exponential moving averages as starting points. Or perhaps the fibonacci retracement levels. But a key point is to make sure you have cash at all times.

Start small, and build a position. Expect significantly lower prices, and sell some into bounces along the way. Understand that you are going to take some pain along the way. Just accept it.