What the ‘Price’ is Saying About Iron Ore and Gold

Good news for stocks in the US last night, with both retail sales and employment data disappointing. Retail sales fell 0.4% in January and a revised 0.1% in December, while jobless claims unexpectedly rose too.

How is that good for stocks, you ask? It means more monetary sugar for longer. At least that is what the market is punting on. Actually, it’s what the market has solely punted on for years. All the chips are on red…or black…or whatever. It’s a bet on more asset price inflation.

Meanwhile, the world’s second largest economy is on the verge of a major credit deflation, a fact the developed markets continue to wilfully ignore. Why are they ignoring it? As we mentioned earlier this week, it appears as though ‘core’ stock markets are benefiting from safe haven capital flows as hot money exits the rapidly cooling emerging markets.

But there will be no safe haven from the looming deflation of the biggest emerging market of all – China. The world is too globalised and interconnected. The precursor to nearly all credit bubble deflations is higher interest rates, and you’re seeing that in China now.

The chart below shows the 3-month interbank rate of interest. It spiked higher in December and stayed there. This reflects the determination of The People’s Bank of China (PBoC) to get China’s credit boom under control. Whether it can actually do so is another question.

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Higher interest rates certainly will slow things down, but it will also highlight the hundreds of billions of malinvestment made in China in recent years. You should hope the PBoC get this right. The system is too big for it to lose control.

Ambrose Evans-Pritchard, writing for the Telegraph in London, says:

‘What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.’

But the big issue is how tighter credit in China could transmit to the rest of the world.

The transmission channel to the global banking system is through Hong Kong and Macao. Beijing’s credit squeeze is causing a scramble for off-shore dollar credit to plug the gap. It is this that keeps global regulators awake at night, for foreign currency loans to Chinese companies have jumped from $270bn to an estimated $1.1 trillion since 2009.

The Bank for International Settlements says dollar loans have been growing “very rapidly and may give rise to substantial financial stability risks”, enough to send tremors across the world.

Just to be clear on how this works, attempts to slow credit growth aren’t working so far because foreign currency inflows are filling the gap. It’s thought that businesses are borrowing cheap US dollar loans via Hong Kong and ploughing the proceeds into short-term, high-yielding wealth management products.

But it’s not all bad news. Not yet anyway. Profit results in Australia have been decent so far and profits and profitability are what drives the stock market. Our only quibble is that stocks are not pricing in a skerrick of the rapidly rising and considerable risk in the economy of our largest trading partner.

Take ‘diversified’ miner Rio Tinto for example. It reported a much improved annual result, with cost cutting proving the feature. Underlying earnings hit US$10.2 billion for 2013. But it was all thanks to the iron ore division which contributed underlying earnings of US$9.86 billion.

Rio looks well priced, trading on about 10 times 2014 expected earnings. But rapidly declining iron ore prices will severely damage those expectations. It reminds us of the way the market priced the homebuilders in the US prior to housing bust.

The largest builders all traded on single-digit price earnings (PE) ratios. Were they cheap, or a value trap? Clearly they turned out to be very big value traps. If you look at the big iron ore miners today, they’ll all trading on low to single-digit PEs. Fortescue for example trades around five times 2014 expected earnings.

Value or value trap?

We think the latter, but who really knows? What we do know however is that at resource cycle peaks and troughs the market is pretty consistent at how it prices companies. For example, at the bottom of the cycle many companies will look expensive based on forward estimates because analysts are not anticipating higher future profits. They always upgrade profit expectations well after the cycle has turned.

At cycle peak, however, company’s trade on low PEs for the very same reason. Analyst profit expectations remain robust out into the future, as they don’t anticipate the cycle turn…they only follow it down.

With that in mind, consider that Australia’s largest goldminer, Newcrest, is trading on a forward PE of around 28 times, while Fortescue is on five times.

Is that the market giving you a pretty good indication of where the respective cycles are right now for iron ore and gold? We think it is.

Regards,

Greg Canavan+
for Markets and Money

 

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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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