Anticipating The Inflection Point For Commodities

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Rudi Filapek-Vandyck, Editor FNArena

Share market indices are back above 5000, and hanging around at levels above what used to be No Go territory, but the underlying story hasn't genuinely changed in Australia.

In line with my earlier research, most of the hard work is still being done by 30% (less than one in three) of all equities, including the banks, consumer staples and other relative safe-havens, while another 30% continues to largely move side-ways and the largest group -some 40% of all listed equities- continues to offer short term trading opportunities, but also to cause damage to investor portfolios and to market sentiment in general.

The only changes I have observed over the past few weeks is that energy stocks have now provided market support too and they are to date the sole market sector that has recaptured and exceeded the May high, while large cap resources BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have equally started to move upwards on no specific news or corporate achievements (other than ongoing asset sales).

It doesn't take a genius's brain to figure out what's happening: early movers are (again) trying to anticipate the tipping point that will see investors jump back into the beaten down sectors of the share market, which should cause share prices to rally much higher.

But it's not like we haven't seen this movie before, is it? Strictly taken resources stocks in general have now been in a downtrend for the past 2.5 years or so. Some sectors, like gold miners and iron ore producers, have experienced heavy falls over the period and it only turned worse as we moved through the first half of calendar 2013. The most amazing observation I made throughout this period is that certain share market experts never even hesitated to continue recommending investors stack up on the China-related investment story, but that's something to be explored with more depth another time.

Here's one price chart that perfectly illustrates what I am talking about:
 

The chart above shows the damage done to Alumina Ltd ((AWC)) shares over the period, but there are many more names that come to mind whose charts reveal equally horrid shareholders experiences: Fortescue Metals ((FMG)), Atlas Iron ((AGO)), St Barbara Mines ((SBM)), OZ Minerals ((OZL)), Lynas Corp ((LYC)), et cetera. The list is long and painful, and painfully long for many among you, I am sure (I hope not but that seems a bit naive on my part).

Charts for the opposite 30% look as follows:
 

Here too you know most of the names by now. In my own vocabulary, this group of stocks consists of the following three groups:

– All-Weather Performers (*)
– Sustainable Dividend Payers
– "In The Sweet Spot" Industrial Stocks

Of course, and understandably so, many stockbrokers, advisors, traders, investors and other market participants have been looking at both types of price charts and thinking: surely the ones at the top are too expensive by now and the ones trading at the bottom of their price chart must be poised to make up for the big difference in price action?

It is here that things have become a little more tricky. While it is true the gap between the outperformers and the bottom performers has not been this wide for a very long time (more than thirty years on some accounts), the fact this gap exists does not automatically imply things are ready to normalise any time soon between the opposing sections of the share market. What usually applies to individual stocks, this time applies to whole sectors: sometimes there is a very good reason why certain stocks are cheap. The experience with gold miners and mining services providers these past couple of months have shown exactly that. Both sectors remain the local stand-outs in terms of issuing profit warnings and negative announcements ahead of the August reporting season, once again confirming why their share prices had been slashed in the first place.

It is not difficult to see why some market strategists are sending out reports arguing today's outperformers are not necessarily as expensive as one would assume, while others are trying to convince their clientele it really is time to start looking at those beaten down bottom movers because that's where the obvious value is.

The problem between the two is "timing" rather than value, as virtually nobody is disputing the underperforming 70% of the share market, and the bottom 40% in particular, looks "cheap". But "cheap" is a relative concept, predominantly determined by what can be expected in terms of growth in profits and cash flows. At this point, analysts can put anything in their models and projections, most investors will simply await a turn in the macroeconomic picture before jumping on board the more risky, beaten-down cyclicals. There are some rumblings, here and there, about improving prospects for Europe, Japan and the US, but what resources stocks need to see is improving data from China and from the rest of Asia. Alas, the latter are closely connected to China and there no stimulus has been forthcoming while economic indicators have continued to surprise to the downside.

The easiest way to get resources and resources share prices moving would be through Beijing announcing a fresh stimulus program, even if it turns out a mini-stimulus version, but that was also the case last month, and the previous month, and the month before that month, and investors (those hopeful enough to stick around) are still waiting. Things are definitely moving in China, just not as fast and as favourable as investors would like it to. In the meantime, worries have resurfaced about private and other mountains of debt in the Middle Kingdom.

Goldman Sachs has been releasing some statistics and charts recently and they make for a sobering read. On GS's data, China's total debt-to-GDP ratio has risen by circa 60 percentage points since the global financial crisis, reaching 210% now (well above emerging-market peers). The forecast is it will get to 240% by 2015. This means Beijing is effectively in a similar position as governments in Washington, London and throughout most of the European continent. Debt levels are too high, but tackling them translates into lower growth.

The difference in China is that the problem is corporate debt, not sovereign debt. Regardless, Goldman Sachs has observed some aspects of credit stress data are approaching 2008 levels. However, this time prospects for rapid relief of credit stress via large fiscal stimulus, sharp external recovery, and lower funding costs as in 2009/2010 appear unlikely.

The biggest problem for resources this year has not been China, but the predicted supply response kicking in. Most commentators have retained their obsession for everything China, and sure enough China's demand dynamics remain one important feature that is shaping and re-shaping the industry, but 2013 has all been about supply, supply and supply and this has by now transformed even the toughest commodities markets around; copper, iron ore and crude oil. If you'd ask analysts at Macquarie, resources now need to go through a nasty phase whereby the weaker production is pushed aside and the stronger producers are forced to survive by biding their time and doing all the right things in the meantime.

These are slow processes. Witness how uranium -the big promise for the future- is once again experiencing another down-cycle and yes, the promise is still there, but supply is ample right now and the price continues to weaken. Uranium needs US$70/lb at a minimum to incentivise new projects and sustained exploration activity. Right now the price is about half the required level. You can bet your bottom dollar that by the time industry dynamics make a genuine turn for the better, today's share prices will look like a screaming buy. It'll be 2004-2006 all over again. Having said so, is there still anyone left in the sector who's waiting?

The share price of Paladin Energy ((PDN)), Australia's pre-eminent representative in the uranium space, has now rallied from $0.80 to $1.10 in less than one month, but this week it appears the price is quickly returning to (possibly) $0.80 again. Before that Paladin shares rallied from $0.70 to $1.02 between mid-April and mid-May. I think this is exactly what investors can expect to happen in the resources space from here onwards. There's no deeper knowledge or smart money insights behind any of this. Simply market participants with a high appetite for risk and a technical analysis program on their laptop or pc trying to ascertain whether the next move upwards might be the one everyone is hoping for.

In Paladin's case, and this goes for the uranium sector in general, the answer turned out negative, but hey, we've seen two strong rallies in two months suggesting somebody has been making money out of virtually nothing during the process!

When it comes to commodities in general, I tend to side with the likes of Citi who simply state it is way too early for commodities to have that sustainable upturn. Once again, if this assessment proves correct, Paladin's share price action so far this year shall remain the blue print for the sector in general for much longer. Unless, of course, one understands the principle of "dividend support". I have written on the subject before and note the two stocks that are unmistakably enjoying dividend support in Australia, Woodside Petroleum ((WPL)) and BHP Billiton, have significantly outperformed the rest in the sector so far this year.

More energy stocks, including Oil Search ((OSH)), Santos ((STO)) and Origin ((ORG)), should be transformed into cash cows, and thus dividend plays, over the next 18 months or so. The likes of Paladin can only dream about having such luxury, and their share prices will continue exhibiting exactly that, in my view.

If one agrees with the view of Macquarie (see above) and certainly I believe it is difficult to dismiss it in the absence of either strong growth surprises ahead, another stimulus program from Beijing or serious supply disruptions across the globe, then it is also difficult to see how share price rallies can turn out anything else than temporary unless we can truly see a genuine change in fortune on the horizon. This change in fortune, according to the likes of Macquarie, won't be announcing itself before 2015 as these processes take their time. See uranium. See Paladin Energy.

As is the case with uranium, I predict by the next upturn the gap between demand and supply can once again turn the resources industry into conglomerates of screaming buys. One argument for this prediction is based on the loss of production (and of potential supply) that will be taking place in the meantime. A second argument stems from the fact that, even at lower annual growth numbers for demand in the future, actual demand growth in real tonnages is still likely to accelerate in the years ahead. Below is a recent chart overview for copper by Macquarie analysts, but the same principle essentially applies to all commodities.
 

The argument of the higher numbers in actual tonnages has been used here and there -incorrectly- to predict a continuation of much higher prices for the decade ahead, but this argument completely ignores the fact that supply is in most cases at similar level and thus not much growth is needed to satisfy demand, unless we see cuts and destruction on the supply side. Only then can the law of larger numbers again start playing its role in favour of commodity producers and of investors in the sector.

The best thing to do thus, if you're an investor with the correct risk appetite to take on resources stocks, is to keep your fingers crossed and hope for a lot more downward pressures on the weaker players in each sector in the year ahead. Because that will automatically create a fertile platform for the next upswing.

Having said all this, Credit Suisse's market strategist Damien Boey released an intriguing strategy report on Monday, suggesting that while the trend in prices and in profit forecasts remains negative for the resources sector, several other indicators might be suggesting the sector overall is poised for a sharp rally upwards, exact timing unknown. More importantly, in my view, is Boey's suggestion that investors will at some point start looking through the short term misery and re-base share prices on the improvements that may lie ahead.

What Boey is suggesting is that share prices for resources stocks might bottom well before prices for physical commodities do. He genuinely thinks this might happen sometime in the second half of 2013. It is for this reason the Credit Suisse strategist is warning investors not to get overly bearish on the sector at this point, even though he concedes there could still be more share price weakness in store for small cap and medium sized resources stocks. Start with the larger cap players thus. Most of them have a dividend story to tell. Or increased production. Or both.

What is playing in favour of Boey's scenario is that current FY14 growth forecasts in the Australian share market are overwhelmingly biased in favour of mining and energy stocks, in particular the smaller players. And a weaker Aussie dollar is keeping more Australian companies in business (and improving their operational cash flows) than otherwise would be the case. At what point will these two factors land on the forefront of investors' attention again?

I predict that inflection point will arrive when resources prices regain some kind of an uptrend, even if it's only a weak one, and that probably won't happen unless we see stability returning in China. The likes of Boey at CS believe this might just happen in Q4 this year, but if you side with the likes of Macquarie and Citi whose forecasts for China imply ongoing struggles in 2014 and maybe even in 2015 still, you are now smiling and thinking: well, that seems a bit early.

Whatever your view, just make sure that if your timing is off the mark, you don't have to sell the house because of it.

(This story was written on Monday, 29 July 2013. It was published in the form of an email to paying subscribers on the day).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

****

NEW EBOOKLET FOR FNARENA SUBSCRIBERS THIS WEEK

I have been researching and writing an eBooklet titled "The AUD and the Australian Share Market" in July and this week will see the official release via email to all paying subscribers at FNArena. So keep an eye on your inbox as I am sure you will find this publication valuable in the years ahead. If you are not as yet a paying subscriber, maybe now's the time to consider joining? My previous eBooklet (see below) also still comes as a bonus on top of a 6 or 12 month subscription.

****

DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

****

Rudi On Tour

– I will present at the Trading & Investing Expo in Melbourne, August 23-24 (where FNArena will host a booth) – ticket promotion to follow – title of presentation is "What Works In The Share Market?"

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

– I have also accepted an invitation to present to ATAA members in Canberra in late November

– I might give my final presentation for the year at the ASA's Sydney Investor Hour in December

Click to view our Glossary of Financial Terms