The correlation between iron ore price and the ASX 200 (ASX: XJO) resources sector
The chart below shows the very close correlation between the iron ore price and the ASX 200 (ASX: XJO) resources sector.
(Charts dated 11th February 2021)
When you look at this chart you begin to realise that it really doesn’t matter what the broker analysts say, what the earnings forecasts are, what the return on equity of the Brazilian subsidiary of BHP (AXS: BHP) is or what anyone thinks. When you are trying to decide whether to be in the resources sector or not it is all about guessing what the underlying commodity prices are going to do next.
BHP, Rio Tinto (ASX: RIO) and Fortescue Metals (ASX: FMG) can look cheap or expensive, but it really doesn’t matter, their share prices are inextricably tied to commodity prices and in particular, the iron ore price.
That makes them great long duration trading stocks, great proxy trades for the less volatile commodity prices. You can make significant and accelerated gains in short periods of time in the Australian resources sector compared to the industrial stocks and the market as a whole which is less volatile. But only if you can time the sector and that means one thing – timing commodity prices.
The game at the moment, with the iron ore price up from $80 to hundred and $60, is to decide whether the iron ore price rise is sustainable or overbought. It is the million-dollar question. Capital Economics say they expect the iron ore price to drop to $100 per tonne by the end of 2021. Now $159.74. Morgan Stanley research out on February 3 said that the iron ore price, under that bull case scenario, would hit $215 by the end of this year. On the same day a UK broker put out some research saying “We expect continued weakness in the iron ore price with the market increasingly oversupplied as the year progresses”. Everybody’s guessing.
In which case your best bet is probably to trade it on trend, on charts. Applying technical analysis is something everyone can attempt, it is a “commodity art”, available to all, because when it comes to resources, fundamental analysis is pretty hopeless. Even the people who know the industry, trade commodities, research stocks and commodities in depth, disagree.
So what do we do with BHP and RIO and the other Australian resources stocks geared to commodity prices?
For now, especially with results and dividends around the corner (BHP on Feb 16, RIO on Feb 17, FMG on Feb 18) and with the iron ore price holding these higher levels for the moment, and with BHP on a PE of 12.2x and a yield of 8.1% (including franking) with RIO also on a PE of 12.2x with a yield of 7.8%, and with FMG on 7.4x with a yield of 14.7%, ahead of what are likely to be record results for the six months from June to December last year, there is no fundamental reason to sell, and as yet no technical reason to sell either.
But…do not think for a moment that those fundamental numbers mean the share prices can’t fall. As soon as the iron ore price falls over, you’d better believe it, so will the share prices, no matter the yield, because as soon as the iron pore price falls, the earnings numbers and the dividend forecasts will be downgraded, literally on a daily basis.
So I hope that makes a few points clear:
- Forget fundamentals when analysing resources stocks.
- Commodity prices drive share prices.
- Respect the trend in commodity prices, it is the “wind” beneath the wings.
- Australian resources stocks are great long duration trading stocks.
- Australian resources stocks offer great leveraged exposures to commodity prices.
- Get the commodity prices right and you’ll get the share prices right.
- Do not stand like King Canute saying stocks are cheap when commodity prices drop.
- Stocks are much more geared than the underlying commodity prices so play stocks not ETFs over commodities.
Here are a couple more charts which make it very clear that this commodity price correlation phenomenon is not confined to BHP, RIO and iron ore.
This is Woodside Petroleum (ASX: WPL) and the oil price:
This is the Energy sector and the oil price:
This is the Gold Sector and the Gold price:
Oz Minerals (ASX: OZL) and the Copper price:
Alumina (ASX: AWC) and the Aluminium price:
I could go on. Point being, the fundamentals, the PE, earnings forecasts, yield, broker recommendations and broker target prices are only as good as the commodity price forecasts. It’s a wonder really why any analyst ever bothers visiting the big resources companies. All their analysis, all their insight, all their experience, counts for nothing is their commodity price assumptions are wrong.
In which case, you don’t analyse BHP, or RIO, Fortescue Metals or Oz Minerals, you’d be better to analyse the iron ore price, the oil price or the copper price, because unless you have an insight into the future of commodity prices, you have nothing to offer doing fundamental analyst of the individual resources stocks.
The good news is that commodity prices trend. They have big trends, some that last for years, and these provide solid “tides” for the stocks involved. If you can catch/spot/predict the big pivot points in the major commodity prices, investment becomes very easy in Australia.
And if you don’t have an insight into commodity prices and can’t spot/predict the big pivot points based on industry knowledge, you still have a chance if you resort to technical analysis. Where there is a trend and the occasional trend changes, you have a chance, which means you have a chance of exploiting the resources sector for the accelerated gains on offer in the sector. And accelerated gains they are. Oz Minerals is up 235% in the last year against the copper price up 87%. FMG is up 211% against the iron ore price up 111%.
Bottom line, as an individual investor, you could do a lot worse than forget fundamental analysis on resources or their more boring colleagues the industrials and focus instead on one or two commodity prices, find out everything about them, what drives them, the seasonal moves, the daily chatter, and take a view.
Unfortunately of course almost all the commodity prices are pumped up at the moment and the next pivot point is likely to be a peak. “When to sell” is the debate at the moment although ahead of record results and dividends and without a significant commodity price peak which is not on the charts at the moment. The “When” to sell is probably not “Now”.
And when they do all fall over…you can always buy gold and gold stocks.