There is a long list of contenders for 2016’s Factor X – the big market-moving event that surprised investors. They include Brexit, Donald Trump’s ascension to United States President-elect and the remarkable rally in resource shares.
For mine, the resource sector stole the show and is a clear winner for Factor X. Brexit and the US election were, for the most part, close-run affairs. Even diehard contrarians would not have seen 70% gains in BHP Billiton and other key miners from this year’s lows.
But it is time to take some profits in resource shares after a rally that appears to be driven more by investor sentiment and fund flows than commodity and economic fundamentals. A rally that has questionable foundations.
That does not mean dumping resource shares or making rash decisions. Identifying an interesting stock to buy is one thing; suggesting investors sell an overvalued stock is a different beast, for so much depends on the entry price, overall portfolio and investor goals, and tax position.
Those who snapped up BHP Billiton at its 52-week low of $14.06 in January, or Rio Tinto at $36.53 earlier this year, are sitting on paper gains of 70% and 60% respectively in less than a year. Those who bought Fortescue Metal Group at its $1.44 low are up 322%.
This is the stuff of a rampant bull market, not one that faces the headwinds of lacklustre global economic growth and persistently high volatility and uncertainty. After falling too hard, resource stocks have rallied too far, too fast. Some profit-taking is required.
Consider recent gains in commodity prices. Spot iron-ore prices (with 62% content) have doubled from this year’s lows in January to US$79.81 a tonne. They jumped about 20% this month alone. Few saw that coming.
Copper, a bellwether for global economic activity, has jumped from US$2.10 a pound in late October to US$2.47. After lagging other metals for much of 2017, copper roared to life this month after Trump’s election victory.
Chart 1: Copper
Coking-coal prices have rallied from under US$80 a tonne a year ago to US$308 a tonne this week. Supply interruptions and production cutbacks, and a pro-coal US President-elect in Trump, are boosting a sector that many investors gave up on last year.
Trump’s election win was like gasoline to a simmering resource rally. After initially buying gold, investors decided Trump was good news for US economic growth and the world economy, thanks to his lower-taxes and infrastructure-spending mantra.
Markets appear convinced Trump will moderate at least some of his controversial election promises and have a more conciliatory style as President than he did while campaigning. That potential is stronger US growth without the damaging consequences of a potential trade war with China and other isolationist policies he promoted.
Risk on, or risk off?
A clear divide is growing: there are those who are buying “risk”, believing Trump’s policies will stimulate the US economy and commodities markets in particular. They are buying resource stocks, companies exposed to infrastructure spending and growth cyclicals.
Others believe Trump will add to global economic risk and uncertainty. The details of several of his key policies are sketchy – it’s a guessing game as to whether he will tone down his election promises, or how other countries will react. These investors are buying gold (which has sold off too far since the US election) and increasing portfolio cash weightings.
I believe Trump will be good for US economic growth, though not by nearly as much as markets are pricing in. His infrastructure plan, encouraging as it is, lacks detail. And large infrastructure projects typically have long lead times and much debate. Oh, and there’s the small matter of how the US Government will fund substantial new infrastructure investments, even though Trump says the plan will be deficit-neutral.
Then there’s China. Trump’s policy position was to label China a “currency manipulator” and bring trade cases against it. Should he follow through on his rhetoric, which included hefty tariffs on Chinese imports, China’s economy could be badly damaged. That is the last thing commodity markets need given the importance of Chinese minerals demand.
US politics aside, latest economic data from China suggests its economy is not picking up as strongly as expected. Most countries would kill for annualised economic growth of 6.1% in October, but markets wanted a little more. China’s economic gains this year are solid rather than spectacular, by its standards; certainly not enough to warrant soaring commodity prices on the demand front.
Commodities, too, give clues about the sustainability of recent price gains. Short covering and momentum trading, where algorithmic trading programs chase uptrending asset prices, are arguably the main drivers of recent gains in iron-ore prices.
Moreover, stronger-than-expected Chinese steel demand has supported price gains this year, but a likely moderation in steel output over the next six months will weigh on the iron-ore rally. Iron-ore supply is plentiful and higher prices will encourage greater supply.
Macquarie Equities Research this week wrote: “Iron-ore market fundamentals remain unchanged, and we continue to believe prices have clearly overshot on this recent speculative rally and should soon ease back to trade in a fundamentally supported $US45-55 a tonne range before long.”
Production: analyst reaction is telling
Perhaps the best indicator of the commodity rally’s sustainability is producers themselves. Several marginal, higher-cost producers that exited markets, such as coal, have not brought production back on line as bulk metal prices have risen. That suggests they doubt the commodity-price strength will last.
Let’s not forget that global economic growth remains moderate – 3.1% on International Monetary Fund forecasts, if one can believe them. Economic, trade and sovereign risks are rising, so it’s hard to see a big uplift in commodity demand. Nor can one see a large enough drop in commodity supply to justify this year’s incredible price rally.
Finally, consider mining company valuations. At $24.55, BHP Billiton is trading about a third higher than the mean price target of $18.19, based on the consensus of 23 analysts who cover the stock. Either the market is hopelessly wrong on BHP, or Australia’s largest mining company has rallied too far, swept up in the latest commodity euphoria.
Chart 2: BHP Billiton
Source: Yahoo
Rio Tinto, at $58.95, trades 36% higher than the mean price target of $43.39, based on a consensus of 18 analysts. Fortescue is trading 80% above its consensus price target of $3.36 and Woodside is 23% above its mean consensus price target.
Chart 3: Rio Tinto
Source: Yahoo
Chart 4: Fortescue Metals Group
Source: Yahoo
Consensus analyst forecasts, hardly infallible, are already factored into share prices: the best gains come from identifying when the consensus is badly wrong, as has been the case with BHP, Rio and Fortescue this year. But even the most bullish broking forecasts on these stocks, outliers from the consensus, are struggling to keep up with recent prices gains. Some broking firms, starting to lift their commodity price forecasts, will increase mining company valuations. But analysts, sensibly, are questioning the sustainability of recent gains in mineral prices in their valuations and have commodity forecasts well below metal spot prices.
This analysis is not meant to disparage the prospects of BHP, Rio or Fortescue. Rather, it’s a reminder that every stock has its price. Nor does it imply the resource rally will fall in a heap anytime soon; as more fund managers rotate out of interest-rate-sensitive stocks (as bond yields rise) money could find its way to the resources sector. There is plenty of short-term momentum behind the resource trade. Still, the big miners are trading above their intrinsic or fair value, boosted by investor sentiment that Trump will send the US economic growth engine up another gear. I’m not as optimistic.
There’s a case to reduce exposure to resource stocks and increase cash holdings in portfolios, in anticipation of better value in the next 3-6 months. Global equity market valuations, particularly in the US, are stretched. A potential bear market in bond prices, and rising bond yields, is a growing concern for sharemarkets worldwide, for it affects equity valuations.
A large overweight position in resource stocks, a dream ride in 2016, will be a significant portfolio threat if Trump disappoints and markets inevitably reassess the global economic outlook and the fundamentals supporting this commodity-price surge.
This year’s Factor X in resource shares could be next year’s Factor Why?
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines.All prices and analysis at November 15, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.