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Paulo Santos, Think Finance (377 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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Three factors have unleashed a massive euphoria on cyclical stocks in the last two days. These were:

  • The ECB's proclamation that it will buy limitless quantities of troubled-nation debt, as long as these are under austerity programs;
  • China's new stimulus program, amounting to $158 billion in infrastructure projects;
  • And finally, today's weak NFP print, which led to renewed speculation the FED will decide on further quantitative easing printing during its September meeting.

This speculation seems misguided

The ECB said nothing new. It won't buy bonds if the countries in question are not under austerity programs, so it won't buy Spanish or Italian bonds right now.

China's new stimulus program amounts to 2.1% of GDP, will be implemented over several years, and most importantly, it mostly gives continuity to past investments. That is, if China decides to build 1000km of new roads in a given year, and then decides to build 1000km more in the next year, while this provides for a "stimulus announcement", it doesn't carry any growth for basic materials per se. As such, this stimulus doesn't change much.

Finally, it's hard to see how the FED will really print more with the markets putting on multi-year highs. The reason for the FED printing - the way it transmits its intentions to the general economy, is by taking markets higher. If the markets are already rallying, it makes no sense for the FED to print into them.

Sectors seeing wild speculation

Iron ore

It's not a surprise to see stocks such as Rio Tinto (RIO), Vale S.A. (VALE), BHP Billiton (BHP) or Cliffs Natural Resources (CLF) rallying hard either on central bank intervention or on China stimulus. However, as the dust settles in the next few days, what we should see is that iron ore itself will stabilize at or under $100 per ton. So the majority of the recent drop from $138 per ton won't go away. As this settles, it will filter into the speculator's minds that nothing much changed.

Coal

The action on coal stocks shows even more clearly how speculative the entire cyclical rally is. These are stocks, like Arch Coal (ACI) or Alpha Natural Resources (ANR) which are mostly bound by the realities of the U.S. coal market, yet they're rallying 8-13% today. Sure, some temporary relief can come from higher met coal pricing. But thermal coal in the U.S. will continue to depend on power generation, and power generation demand for coal will continue to be guided by the price for natural gas. Now, natural gas is trading at $2.70, which again puts it below the range where further coal->natural gas substitution again takes place. This means thermal coal cannot increase in pricing and will again see reduced utilization.

In short, coal presents the clearest case for there being little to celebrate in these cyclical developments. Yet the stocks rally strongly.

I'm not saying coal can't be an interesting long-term preposition. As soon as natural gas production drops significantly from the reduced drilling, that can be the case. Yet these last few days led to strong speculative rallies which did not consider the fundamental issues at hand. This makes it likely that the rally will be temporary.

Conclusion

I believe the strong rallies many cyclical stocks achieved during the last 2 days are temporary and speculative in nature, and that these gains will be lost in the next few weeks, as reality sets in that the causes for this rally don't change fundamentals much.

The only caveat here is that the rallies might indeed sustain for longer if the FED decides to print even into a market making multi-year highs. It's hard to say how speculative the market can get under such a scenario.

Source: Massive Cyclicals Euphoria