XME: It Depends On Your View Of The Future – SPDR S&P Metals and Mining ETF (NYSEARCA:XME)

A whiff of inflation – although the rate of inflation remains “muted” according to Federal Chair Jerome Powell – and anticipation of lower interest rates has encouraged investors to speculate in the SPDR S&P Metals & Mining ETF (XME).

The XME is a very pro-cyclical investment, as the fund is comprised of companies involved in steel, precious metals, diversified metals and mining, as well as aluminum and coal.

The fund focuses exclusively on U.S. companies. While some of these companies have foreign operations, an investor in XME is not exposed to companies headquartered outside the U.S.

Top five holdings in the index

• AK Steel Holding Corporation (AKS) – steel manufacturing
• Royal Gold, Inc. (RGLD) – royalty claims on gold, silver, copper, and other materials
• Coeur Mining, Inc. (CDE) – precious metals mining
• Steel Dynamics, Inc. (STLD) – steel manufacturing
• Commercial Metals Company (CMC) – steel manufacturing

Unlike many ETFs, whose holdings are weighted by market capitalization, the index is designed to “track a modified equal-weighted index which provides the potential for unconcentrated industry exposure across large, mid and small cap stocks.”

The largest holding in the index as of July 30 was AK Steel Holding Corp. with a weight of 5.85%.

The fund’s gross expense ratio is 0.35%, which is higher than the expenses of many other SPDR funds.

Fund performance can be characterized, at best, as mixed:

Fund Performance

Source: SPDR XME as of July 31, 2019

Investing in XME means acceptance of some volatility.

For July, you can see the volatility in the fund as investors shift their outlook on the U.S. economy.

Source: seekingalpha.com, extracted July 31, 2019

Ironically, the Federal Reserve’s latest 25 basis points cut on July 31, which should have helped these pro-cyclical stocks, actually took the fund lower. The Fed’s announcement came at around 2:30 pm Eastern Time, and you can see the market’s reaction.

Source: seekingalpha.com, extracted July 31, 2019

Is XME right for you?

The best way to answer that question is to create different scenarios of possible future events. Part of your answer depends on whether you believe (A) that the Federal Reserve will do “whatever it takes” to support the U.S. economy and (B) that the actions of the Fed will be enough to prevent the economy from falling into recession.

Let’s consider some economic scenarios.

Scenario 1. U.S. falls into a recession and the world follows even though the Federal Reserve lowers interest rates

While the companies in this index are capital-intensive and should benefit from lower interest rates, the question is whether lowering interest rates will boost the “real” economy?

Stocks in XME are geared towards a growing economy. If the U.S. falls into a recession and the rest of the world follows into an economic recession, even with lower interest rates, then the U.S. dollar will remain strong relative to other currencies, as the U.S. economy is more resilient than economies in other parts of the world.

The strong U.S. dollar weakens the case for precious metals as gold is priced in dollars and buying gold is a bet against the dollar.

At the same time, metal producers and fabricators’ stock prices will fall as sales drop due to the general downturn in the economy.

If you believe this scenario, you can skip the rest of the article. XME has no value for you.

Scenario 2. Trade peace is declared and global markets rebound as the dollar weakens

The trade wars end and markets around the world rebound. All that talk about the end of global markets fades away. In this scenario the U.S. dollar falls as other currencies gain strength along with their strengthening economies.

Because the dollar falls, precious metals become more valuable as inflation again becomes a concern.

Metal producers and fabricators’ stock prices rise as a growing world market cries out for more raw materials to support fast-growing economies.

We had this scenario between 2009 and 2011, and the XME responded appropriately.

Source: finance.yahoo.com, extracted July 31, 2019

In this scenario, putting all your money into XME is a no-brainer. Enjoy the ride.

Scenario 3. Trade war continues (or even intensifies) and the dollar remains strong

Protectionism is not a dirty word for most of the metal producers in the XME. High trade barriers keep cheaper foreign imports out of the U.S. market, allowing domestic producers to raise prices.

At the same time, the strong dollar dampens any increase in the stock prices of companies focused on precious metals as gold and silver are priced in dollars.

In this scenario, precious metal producers are suffering even as other metal producers are thriving. So, one part of the XME fund is essentially fighting the other.

You are better off choosing individual stocks from within the fund than buying the entire fund.

Scenario 4. Recession hits the U.S. even as China remains economically secure and the rest of the world’s markets shift towards China

In this situation, a rebound in global markets even as the U.S. economy falls results in a falling dollar. A falling dollar is good for precious metal producers, so that part of the XME holdings will do well.

For other metal producers, the falling dollar will help exports even though domestic demand will be declining due to the slower economy.

A U.S. recession while the rest of the world surges makes domestic tariffs a moot point, as foreign producers can focus on their non-American markets.

Just as in Scenario 3, you are better off picking individual stocks than investing in the whole index.

Buy the precious metal companies and any of the other metal producers who have significant export business. Avoid those metals companies focused on the U.S. market.

Scenario 5. The economy stays like it is at its present “Goldilocks” level

The current economy is the future economy. Interest rates stay mooted and the “real” economy keeps humming along with a GDP growth rate of between 2% and 3%.

Precious metal companies are doing well at present levels but don’t see much upside from current prices.

Other metal producers continue to do well as demand continues and tariffs continue to protect from any surge of imports.

In this situation, the XME fund price will probably slide down from its present level as many current investors are speculating on a stronger, more inflation-fueled economy and will drop out of the fund if economic conditions appear to remain unchanged from current levels.

The current economy favors service-focused industries over product-focused so investors will probably leave the XME until they sense another hint of inflation.

Conclusion

Investing in the XME requires a certain macroeconomic outlook. In at least four of the five scenarios (1, 3, 4, and 5), the XME is headed for a fall of some sort.

It is only in Scenario 2 that XME makes investment sense.

Although the index as a whole may not be the investment vehicle of choice, don’t overlook one other use of the XME – the list of its holdings.

Individual investors may want to look over its holdings for possible individual stock picks.

Because they are in the XME, if investors suddenly choose to abandon the fund, the stocks in the holdings will suffer price declines even if their fundamental value remains strong.

While all of these companies are pro-cyclical, many are in good financial shape with some interesting P/E ratios compared to the market.

Most all of them have a plan to survive any possible downturn, and many are working to reduce their debt levels.

If any of these stocks decline in value, they offer interesting possibilities for the alert stock picker willing to live with the volatility.

You may choose not to invest in them at present, but put them somewhere on your alert list for the future.

As always, do your own research before buying or selling any investment.

Disclosure: I am/we are long CMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.