The Iron Ore Bust Hits – From West to East

Wall Street continues to recover from last week’s panic sell-off. The S&P 500 jumped 1% overnight while the rise in the Dow was up a more modest 0.2%.

A positive update from Apple was enough to offset bad news from IBM, or so the media tells us. More than likely, this is just an ongoing ‘technical’ rally to restore some calm and balance following a few wild weeks of trading.

The S&P 500 is now nudging up against its 200-day moving average, which is a widely followed long term trend line. Just recently, the index broke down below this trend line for the first time since late 2012.

It will be interesting to see whether it can move sustainably above this level and resume the bull market, or whether it brings about a new wave of selling.

There’s still a lot of bullish optimism out there…and a feeling that if anything goes wrong, the Fed is there to serve and protect. Wait a minute…isn’t that the LAPD’s motto?

I think it is. Which makes sense, because the Fed certainly acts like a baton wielding cop, beating short sellers and turning a blind eye to thieves and chisellers.

In fact, it makes perfect sense. Capital markets are a police state!

Don’t worry, I’m not going to get stuck into central bankers for perverting the course of capitalism and economic development in today’s Markets and Money. But you can be sure I’ll come back to it.

There is one thing that I did want to show you though before I move on. I was looking through Dr Ed Yardeni’s website this morning, which has an amazing amount of market data, and was looking at the relative performance of industry sectors compared to the S&P 500 itself.

Get this. Since the start of the bull market in March 2009, consumer discretionary stocks have outperformed the S&P 500 by a massive 124%. Other outperformers include industrials (55%) information technology (32%) and financials (80%).

Meanwhile, energy stocks have underperformed the index by 83%! If you’re looking for relative value in the market, it’s not a bad place to start. If you want some ideas, check out the latest report on ‘oil wildcatters’ by Diggers and Drillers analyst Jason Stevenson.

It is an almost iron clad law of the market that prices rise above, return to, and undershoot, the mean. Outperformance gives way to underperformance…and so on and so on, like a massive pendulum.

So what should you make of the massive outperformance of the Aussie economy then? We haven’t had a recession in nearly 24 years. Does that mean we’re in for a long bout of underperformance? Probably.

Billionaire businessman Kerry Stokes reckons economic conditions in WA (his home state) are the worst they’ve been since the recession of 1991. The iron ore bust is hitting the West hard. And it’s slowly but surely heading east.

But at least Kerry isn’t carrying on like a pork chop over BHP and Rio’s iron ore expansion plans. That’s despite having a stake in iron ore junior BC Iron…a stake that is now half the value of what it was two months ago thanks to falling iron ore prices.

Giving advice to billionaires is easy when they are not listening, so Kerry, let me say this: Don’t expect to get anything back from your iron ore investment. It will produce at a loss for a few years, before it wipes out equity investors and goes into administration…a forgotten relic of China’s historic credit and building boom.

Call it a return to the mean. Before the China boom, iron ore traded for as little as US$20/tonne. At the height of the craziness in 2011, it went for nearly US$190/tonne.

Yet at the time there were very few calling it a bubble. Unlike the situation in gold in 2011, when there were bubble callers everywhere.

One man who was calling it a bubble was Dr Michael Pettis, a widely followed academic economist who specialises on the Chinese economy. Normally, academic economists are so full of theories they can’t make the real world fit.

Pettis is different. I’ve read his work for years and his writing is always insightful…but more importantly, it’s full of common sense analysis and observation.

His latest piece is no different. In it, he talks about Australia and iron ore. He recounts a story about a dinner speech he gave to a bunch of mining industry investors in Sydney three-and-a-half years ago. He told them that when China starts the process of economic rebalancing, iron ore prices would fall at least 50%.

This is because any shift in Chinese demand for iron ore will necessarily be a big shift in total demand. China consumes about 60% of global iron ore production, an extraordinarily high share probably unmatched in history except perhaps (I am not sure) by England in the mid 18th century, when it was pretty much the only country in the world building machines, railroads, and iron bridges. This would be an astonishing consumption share even for the United States at its peak share of global GDP (around 33% in the late 1940s?), and so was all the more so for a country that represented only 12% of global GDP.

China’s disproportionate demand for iron was clearly the result of its intensely investment-driven growth model. This would change dramatically, I told the guests. I expected that the shift in demand for iron ore generated by rebalancing would cause iron ore prices within 3-4 years to drop by over 50% from their then-current levels of around $180-90 a ton.

After this conference, Pettis began looking deeper into the connection between investment driven growth in China and iron ore prices. He concluded that before the end of the decade, the iron ore price would fall below US$50/tonne.

He’s not just plucking this number out of thin air for effect. He bases his analysis on China’s expected nominal economic growth rate within the context of economic rebalancing. That is, China moving away from investment driven growth and more towards domestic demand. If this desire to rebalance continues (and it’s only just starting), expect more falls for iron ore.

The interesting point to note is that people are now starting to take notice of his forecasts. Pettis writes:

Early this week I was with an Australian government representative in Beijing whom I have known for many years and he told me that iron ore prices were currently around $83 (I think they dropped another $2 last week), and that while some people in Canberra were reluctant to say it too loudly, he and others were increasingly in agreement with my lower forecast of less than $50 well before the end of the decade, in part because supply has come off much more slowly than predicted, but mainly because they now recognize that China’s rebalancing was indeed going to be a far bigger deal for Chinese demand than sell-side research had predicted.

Australia had better come to grips with this sooner rather than later. We don’t have a budget or an economic structure ready to handle US$50/tonne iron ore prices. We have put all our chips on China and rolled the dice.

We’ve been lucky so far, but our luck is about to run out.

Western Australia is just starting to see what it feels like. But don’t think it’s confined to the West…the bust will slowly rumble across the Nullarbor and hit the eastern states too.


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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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