Treasure Chest: Time To Short The Mining Sector

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

By Greg Peel

Shares in BHP Billiton ((BHP)) have bounced over 24% from their June lows and Rio Tinto ((RIO)) has seen a 30% recovery. Miners on average are up 30%, notes JP Morgan.

Late June represented a bottoming out of this year’s round of China slowdown fears. The initial impact of financial and fiscal reforms implemented by Beijing early in the year, which derailed previous expectations of a solid start to the new year under a new regime, had run its course and China’s PMI numbers began to turn around once more.

Throw in stubbornly resilient iron ore prices, belying analysts’ expectations of a seasonal pullback, and investors became a lot more confident in buying previously sluggish resource names. The world was looking brighter and risk was back “on”.

JP Morgan elected in June to close its longstanding Underweight position in mining on a belief the sector, and sentiment towards China and emerging markets, had overshot to the downside. It was a good call, and now JPM has decided it’s time to reinstate. The 30% rally is not in itself the only reason, albeit bear market rallies in the mining sector tend to last 4-5 months and deliver 30-35% upside, the analysts note, and those boxes have now been ticked.

JP Morgan also notes speculative copper shorts were at a record high in July, but gone (short-covered) by October. Mining stocks tend to follow the fortunes of Chinese equities and after a brief bounce, Chinese equities have now rolled over relative to developed market equities. Iron ore prices usually run up towards year end on seasonal restocking, but this year there was no seasonal destocking to send prices down in the third quarter. While China’s PMIs have improved, JP Morgan believes momentum likely peaked in the third quarter ahead of a more subdued fourth quarter.

Miners are not cheap at these levels, JP Morgan points out, trading at a 21% premium to historical average price/earnings. The analysts believe forecasts of 30% net earnings growth in 2014 and 20% in 2015 seem ambitious.

The broker admits the current plenary meeting in China suggests a risk of something out of left field, but in the meantime Chinese credit growth is outpacing GDP growth and fixed asset investment has accounted for an “extreme” 56% of GDP in 2013. If Beijing is looking to rebalance the Chinese economy, it may be time for further policy implementations which might again imply short term disturbance.

Goldman Sachs’ analysts have looked at the resource sector from a different angle. Costs have been reducing for miners following the peak in mining sector spending, suggesting a period of cost deflation. This negatively impacts long term prices and margins, Goldman notes, and thus mining company valuations.

Goldman has lowered its resource sector view to “Unattractive” from “Attractive”.

JP Morgan sees its Underweight rating as a 3-6 month call, or perhaps longer.
 

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