The Best Trading Stocks In Australia

The Importance of Correlation in the Australian Stock Market

 

Note to Reader – When you are looking at the correlations on the charts below a high correlation is when the turning points are aligned. Don’t worry about whether the lines overlap and how big the gap is between them, it’s a bit irrelevant, they are on different scales with different percentage movements. The important observation is that they bottom together and peak together. That’s a high correlation.

Charts dated 18^th June 2024

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EXTRAORDINARY CORRELATIONS

This first chart shows one of the most obvious correlations in the Australian stock market. It is FMG and the iron ore price. FMG produces iron ore and sells 100% of it to the Chinese. Remember, look at the correlation of the turning points not whether the lines overlap. This is one of the closest correlations in the market.

When you look at this correlation, you begin to realise it really doesn’t matter what the broker analysts say about FMG, what the earnings forecasts are, what the return on equity is or what anyone thinks about the management. When you are trying to decide whether to buy or sell FMG it is all about guessing what the underlying commodity price is going to do next. FMG does not dictate the iron ore price. The iron ore price tomorrow dictates what the share price of FMG (and BHP, and RIO, and CIA….) is going to do tomorrow, and it’s so close a correlation that the iron ore price dictates the share prices literally on a daily basis.

BHP, RIO and Fortescue Metals 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. FMG is almost 100% dictated by the iron ore price. If you analyse BHP and RIO you will find that you could build an algorithm (a fancy name for a simple formula in Excel) that calculates the likely price of BHP depending on the underlying commodity prices their profits and revenue is exposed to and in what percentages.

• BHP gets 46.1% of its revenue from iron ore, 29.7% from copper and zinc, and 20.3% from coal.

• RIO gets 62.4% of its revenue from iron ore, 22.1% from aluminium, 5.9% from copper.

Now you can write yourself a little algorithm that calculates every day what the BHP and RIO share prices should do every day depending on the underlying commodity prices. It may not be 100% accurate, but it’s going to be very close, it’s going to tell you which way the tide is running on a daily basis, and it certainly dwarfs the idea of doing a fundamental analysis based on historic profit numbers of any stocks highly correlated with future commodity prices.

And it’s not just iron ore stocks, of course. The same is true of many stocks in Australia (and the world) that are making money out of a commodity. Be it oil (there are hundreds of energy stocks linked to oil, gas and energy prices), gold (plenty of gold stocks), silver, platinum, copper, uranium, lithium, zinc, aluminium, nickel, rare earths, even grain crops, wool, cheese, coffee, wool and other soft commodities. There are many many correlations between stocks and commodity prices.

The difference between stocks with commodity price correlations and stocks priced on industrial earnings is that commodity prices are volatile and can trend for long periods. Generally speaking the earnings of Woolworths, the Commonwealth Bank and boring stocks like Amcor rely on business success rather than unpredictable and volatile commodity prices.

That makes resources stocks more risky and volatile but at the same time they make great long duration trading stocks, and provide wonderful proxy trades for the less volatile (boring – not worth trading) commodity prices.

Look no further than lithium. It has boomed and the past. Whilst that may scare many investors away, the reality is it has been a fantastic opportunity to make serious money in the stock-market and for those trying to make gains rather than earn income, this sort of volatility is a godsend. Look no further than Australia’s largest lithium play Pilbara Minerals (PLS). Market cap $9.81bn. Trading at 326c. In 2020 you could have bought it at 13c. Last year you could have sold it at 566c. A 43 bagger.

Now that’s an opportunity you almost never see in industrials.

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And then there’s the slowest moving of the lot – BHP.

• Since the pandemic BHP has offered 13 tradeable moves averaging 33%
• BHP has had six rallies averaging 44% since the pandemic (+68%, +61%, +51%, +22%, +40% and +22%).

Here is the BHP chart since the pandemic showing the rises and falls since 2020.

To save you working out the moves on the chart above they include a drop of 42%, followed by moves of +68%, –17%, + 61%, –35%, +51%, –18%, +22%, –25%, +40%, –17%, +22% and –17%.

Resources are a fantastic sector for investors. 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. Compare trading a stock that is highly correlated to the iron ore price, a stock that will move 20 to 50% in a single trend which may take months or years), to investing in the Commonwealth Bank whose revenue and profit is highly predictable.

We are blessed as investors in a resource-based economy like ours because we have the opportunity to trade these large, low volatility, high trending stocks. But only if you can time the stocks and their trends and that means one thing – timing commodity prices.

The way to do that is to study the industry trends, supply and demand, pivotal events, as well as apply technical analysis, because when it comes to resources, fundamental analysis of individual stocks using last year’s numbers based on last year’s commodity prices, is pretty hopeless. You would be far better off studying the outlook for commodity prices than a history of profit numbers.

Another quirk of the resources sector is something that any domestic Australian fund manager will tell you holds true. It is when BHP (or RIO, or FMG) are at their most expensive on an assessment of PE and yield, that they bottom. And it is when BHP (or RIO or FMG) look to be at their cheapest that they peak. You will never time resources stocks on fundamentals and any time you read or hear anyone with an opinion that includes an assessment of the BHP P/E ratio or yield, you are talking to someone that just doesn’t understand how this sector works.

To summarise:

• 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.
• Anyone quoting fundamentals doesn’t get it.
• Stocks are much more geared than the underlying commodity prices so you get better bang for your buck in a copper stock than the copper price, in iron ore stocks rather than the iron ore price. So play stocks not commodities. Then you can go even more geared by choosing smaller cap companies (ie. 29M vs SFR or RED vs NST).

 

• If you want a slightly less volatile exposure to getting commodities right then have a look at ETFs.

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• This is the Energy sector and the oil price:

• This is the Gold Sector and the Gold price (look at the turning points not the gap between the prices):

• The Copper price and the WIRE ETF and Sandfire Resources (SFR):

• Paladin (PDN) and the uranium 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 if their commodity price assumptions are wrong.

In which case, you don’t analyse BHP, or RIO, Fortescue Metals or Paladin. You’d be better to analyse the iron ore price, the oil price or the uranium price, because unless you have an insight into the future of commodity prices, you have nothing to offer doing fundamental analyst on 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. Paladin went up from $6 to $18 between the middle of last year and last month.

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.

For each commodity price there is a list of stocks to trade as a proxy. Most of them will not just be correlated to the underlying commodity price, they will be correlated to each other. Which one you pick depends on how much volatility you want. Then release the bigger they are the less volatile they are. So if you want a real bang for your buck pick a very volatile commodity price, find a stock with no earnings that trades entirely on sentiment, and buy it.

If you want to play it slow, pick a commodity price, pick an ETF that reflects the underlying commodity price or one of the largest stocks, and wait for a big pivot point at the bottom.

ETFS

• WIRE (Copper stocks)
• GOLD, NUGG, PMGOLD, GXLD (Gold price not gold stocks)
• MVR (Australian Resources)
• QRE (ASX 200 Resources)
• ACDC (Battery Tech and Lithium)
• GDX (Gold Miners)
• FUEL (Global Energy stocks)
• WIRE (Global Copper Miners)
• MNRS (Global Gold Miners)
• ATOM (Global Uranium stocks)
• XMET (Energy Transition Metals)
• URNM (Global Uranium)
• JZRO (Net Zero Transition Metals)

ENERGY STOCKS

RESOURCES (I could have put a lot more in here)

This is a very useful list of the stocks linked to a variety of commodity prices in market cap order. I have also included their volatility as a percentage of the share price both over 14 days and 14 weeks. The weekly number should tell you how much risk you are taking relative to the other stocks. High volatility in pinks, low volatility in blue.

View the list HERE:

Access available to members or those with a free trial.

With this list on your fridge, you can follow commodity prices, pick the pivot points and pick the stocks depending on your risk appetite.

Enjoy.

More about the author – Marcus Padley

Marcus Padley is a highly-recognised stockbroker and business media personality. He founded the Marcus Today Stock Market Newsletter in 1998. Over the years, the business has built a community of like-minded investors who want to survive and thrive in the stock market. This is achieved through a combination of daily stock market education, ideas and activities.

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