Despite Bullish Outlook From Joy Global, The 'Commodity Crash' Playbook Stays Active

 |  Includes: EWZ, JOY, VALE
by: Dr. Duru

While the stock market was oversold, I focused on accumulating beaten-down, commodity-related stocks as part of my “commodities crash” playbook as explained in “Profiting from Physical Assets in a Resource-Constrained World – Rules and Picks.” The swoon in August produced many commodity stocks that erased their post-QE2 gains; I used such milestones to trigger purchases. On rallies, I have chosen to lock in a few profits given the recent sell-off in commodity stocks did not represent the kind of wholesale crash that I was expecting. The main thesis holds that commodity prices will plunge once China’s economy significantly slows down, producing a tremendous buying opportunity ahead of a world where resources will become quite constrained. The most recent earnings report from Joy Global (JOYG) on August 31 confirms that what just happened to commodity stocks did not coincide with a significant slowdown in China nor did it represent a crash. JOYG is even bullish for 2012.

Here are two key sections from the earnings report (emphasis mine):

“There is increasing evidence that slowing is underway in economies worldwide, and that growth in the U.S. and Europe may remain structurally lower for several years. Various indicators of economic growth are declining and moving toward neutral. Worldwide trade, measured by new export orders, remained close to the neutral level in July with the slowing of exports from China, Germany and Japan. Global manufacturing increased for the 25th consecutive month in July, but the rate of expansion was the lowest since 2009. China’s manufacturing index declined in July, but remained positive. Growth also slowed in India, Brazil and Russia.”

By comparison, the fundamentals in the commodity markets have continued to remain strong. The seaborne markets for copper, coal and iron ore continue to be driven by strong demand from China, India and other emerging markets. Although industrial production and export growth is showing signs of slowing in China, massive infrastructure programs should sustain GDP growth at high levels. Imports were reduced as China worked down inventories of copper and coal in the first half of this year, but recent increases of imports have started to replenish these stocks. This move from de-stocking to restocking for copper and coal will support commodity demand even if growth slows. Chinese copper imports grew sequentially in June and July, with June up 10 percent and July up 9.5 percent. Coal imports climbed above the trailing 12-month average in May, and remained above the average in June and July. China’s imports of both copper and coal are expected to remain strong for the balance of the year. Imports of iron ore are up 8 percent over last year, which is consistent with the 9 percent growth in China steel production. Although iron ore inventories have increased in tons, they remain near their historical average in days of supply.”

Taken together, JOYG remains bullish overall for 2012 (emphasis mine):

“… commodity prices have held steady at high levels, despite concerns over the slowing of the global economy. Met coal and iron ore prices are expected to remain near current levels, while copper and seaborne thermal coal prices are expected to increase in 2012. As a result, prices continue to support mine capacity expansion programs. On average, there is very little excess mine capacity versus current production levels. With the longer lead times required in starting up new greenfield mines, demand will exceed current capacity even under slower growth scenarios. With strong commodity prices, positive demand outlook and risk generally to the upside, mining companies continue to move forward with expansion programs. In addition, mining customers have been allocating a higher percentage of their free cash flow to capital expenditures for projects, rather than to acquisitions or capital returns. Capex increases in 2010 and 2011 have returned customer capital expenditures to 2008 levels, and further increases are expected in 2012.”

These descriptions are good reasons for continuing to hold some amount of commodity stocks, but they also reveal the material vulnerability to the bullish case. Prolonged structural weakness in the U.S. and Europe could deliver a stronger than expected impact on the global economy since these regions are China’s biggest trading partners. While it appears for now that China remains willing to maintain massive spending programs through any slowdown, prolonged weakness in the global economy could lower the economic returns on such projects to unacceptable levels, especially if China continues to struggle with controlling inflation. Regardless, it seems over the next several years, the world’s general economic fate will increasingly pivot off China’s well-being. This will present the global economy with a precarious (im)balance.

On the other hand, if China manages to navigate these risks over the coming months, I will increasingly have to assume the window for the commodity crash has indeed passed.

In the meantime, I decided today to sell my holdings in EWZ, the iShares MSCI Brazil Index Fund, and Vale SA (NYSE:VALE) (I register rulebook trades in my twitter feed using a #120trade hashtag). Until I am compelled to alter the existing trading/investing rules for commodity plays, I will redeploy freed-up cash upon erasure of QE2 gains. Any retests of March, 2009 lows (or close enough) will represent absolute steals. (Other rules like buying EWZ on 20% corrections will also remain in place).

Post-earnings trading in JOYG reveals the ambivalence in the market. The stock rocketed as much as 7% right into stiff resistance at the 50-day moving average (DMA) and 200 DMA, but closed with a mere 1% gain. JOYG closed the entire post-earnings gap up at its lowest point in the day.

(Click to enlarge)

JOYG's sharp recovery from 2011 lows may be over for a while

*Chart created using TeleChart

Be careful out there!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JOYG, EWZ, VALE, EWA over the next 72 hours.