Barron's bearish on mining stocks

by: Ezra Marbach

Barron's Vito J. Racanelli suggests (Barron's subscription required) that mining stocks may be headed for a fall. Too much optimism, and growing signs of diminishing Chinese demand are the most significant factors. Here are the key points:


Key points:

  • Due to China demand, commodity prices and related stocks have soared over the past two years.
  • Stoxx sector of European basic resources stocks, has jumped 73% over the past 25 months.
  • 66% of the sector is weighted in miners like Anglo-American (ticker: AAUK), BHP Billiton (ticker: BBL) and Rio Tinto (ticker: RTP).
  • Analysts continue to increase earnings estimates for the sector.
  • There's talk of a "supercycle" of commodities demand (thanks mainly to China).
  • Goldman Sachs (ticker: GS) warned recently of a potential "super spike" in oil to as high as $105 a barrel.

Will the mining rally continue?

  • Assuming China growth continues, so should growth of basic resource companies.
  • BUT, Barron's suggests that a correction may be on the way.

Jacob de Tusch-Lec, a London-based Merrill Lynch strategist:

  • Points to parallels between basic resources stocks, and the tech stock bubble.
  • "....this is a sector which you can't allow yourself to be underweight."
  • But, the rise has been too strong and the sector now so big, that "it is hard to find sellers".
  • The idea that "China will consume anything that the U.S. doesn't" and that its GDP can grow at 8% all the way out to 2050 has firmly taken hold of the market's imagination.
  • The euphoria about China is so thick that investors aren't pricing in any risk.
  • Sounds like the 1999-2000 herd mentality.
  • It's rare for a capital-expenditure and credit boom to have a soft landing, for capex growth isn't a function of the level of final demand growth but is highly sensitive to the changes in growth.
  • If Chinese exports slow, it could have a disproportionate effect on the country's capex spending.
  • If there is a second-half US economic slowdown, "then it might have a much larger impact on China and Asia than the market expects".

Alastair Duffy, a fund manager at Aegon Asset Management:

  • When Chinese demand slows, the resource sector stock prices will fall quickly.

Standard & Poor's equity strategist Charles Dautresme:

  • Steel data suggest a slowdown in production is beginning.
  • The value of January imports of iron and steel declined by 2% from a year earlier.
  • Since steel prices have skyrocketed, that means the imports dropped even more.
  • Chinese monthly steel production is now growing at 26%, down from 31% late in 2004.
  • Further signs of weakening from China could hurt the stretched valuations of mining shares.

On valuation:

  • Resource and mining stocks are trading at about 12X 2005 consensus EPS estimates.
  • While not rich, the valuations are at the top end of the most recent two-year valuation range, according to S&P's Dautresme.
  • Any bad news will cause investors to exit.
  • Basic resources stocks are down 3% over the last 30 days. Of course, this could just be profit-taking.

Conclusion:

  • Even during a lengthy growth spurt, slowdowns are inevitable.
  • A China slowdown may be on the way.

Relative stock market performances of select mining companies:

BHP Billiton (ticker: BBL) in ORANGE.
Rio Tinto (ticker: RTP) in BLUE.
Anglo-American (ticker: AAUK) in GREEN.

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