Base Metal Mania...from this week's Piece Points by Dave Forest.
We had another round of increases in industrial commodities price forecasts this week. Merrill Lynch raised its iron ore forecast for 2010 by 15% to $1.07/ton, and upped its thermal coal forecast by 6% to $85/ton. The bank also increased its forecasts across the board for the traded base metals. Merrill raised its copper forecast 20% to $2.15/lb, bumped nickel by 15% to $6.52/lb, and increased aluminum 10% to $0.75/lb. The bank's commodity strategists said in a note, "The sharp price gains in metals were influenced by an anticipation that the global economy will recover and fundamentals will strengthen."
This is common sentiment these days. Optimism has returned to base metals markets, buoyed by "the China story", the idea that even as metals demand collapses around the world, voracious demand from China will keep metals prices relatively high. Indeed, the news from China has been bullish lately. This week Beijing reported that the nation has stockpiled 500,000 tons of zinc. Largely thanks to record imports during the first half of 2009 of 480,000 tons. That's a 600% increase in zinc buying over the same period in 2008.
But there is an odd disconnect developing between the big picture story and the events on the ground. Particularly when it comes to the performance of base metal mining stocks. With most of the base metals having reached close to year-highs this week, mining stocks have been on a tear. BHP Billiton is up 30% in the last month alone. The stock has nearly tripled from its November low and is on the verge of regaining the level it enjoyed last August before the financial crisis broke. This is a huge move up, especially for a company this large. And it's not just BHP that's been rising. The large-cap mining sub-sector of the S&P Materials index is up 250% from its November low. In 2009 alone, the large-cap mining index has gained 135%.
The action in base metals stocks seems suspiciously strong. Of the 12 other large-cap sub-indices that make up the S&P Materials, the next best performer in 2009 is paper products, up 60%. All other sub-sectors have only managed gains between 0 and 30%. As a whole, Materials is up only 25%. Meaning that large-cap diversified mining companies have outperformed their wider index by more than 400%. And beaten the next-best sub-index by 100%.
The bulls argue that these gains are justified based on the recent recovery in base metal prices. Copper has doubled from its low, to $2.80/lb this week. Zinc is up 70% to $0.85/lb. Even nickel, which had been lagging the recovery, is now up over 100% to near $9/lb. These increased prices should mean increased profits for miners, right?
Kind of. Forward earnings for miners in the S&P sub-index have indeed risen lately, up about 200% since the beginning of 2009. But as of July, forward earnings are still only one-fifth what they were in mid-2008. Let me say that again. Forward earnings are down 80% from their 2008 peak. And yet the mining index is down only 50% from its top last year. Share prices have recovered much, much faster than earnings.
We can see this in P/E ratios. With share prices rising this year (higher P), the average P/E ratio for the mining index soared to above 25. Prior to the crash, ratios had held around 10 for most of the last 5 years. With forward earnings rising because of higher metals prices the last few months, average P/E for miners has crept down to 18 as of July. But this is still nearly double the average of the last several years. To bring things back in line, earnings must rise, meaning we need even higher metals prices. Does anyone want to bet we'll see $4 or $6 copper in the coming months? Is China going to buy another 500,000 tons of zinc? The only alternative is for share prices to fall, lowering P/Es.
So what's really going on? One thing we know for certain is that billions of dollars of investment money have been flowing back into the commodities sector over the last few months as risk appetite returns around the globe. This has certainly played a role in driving up metals prices and miners' share prices. And a lot of investment money tends to follow the trend. Rising prices bring more buying, reinforcing the upward momentum.
It's particularly interesting to see the discrepancy in performance between the large- and small-cap mining companies in the S&P index. As mentioned, the large-caps are up 135% this year. The small-cap miners, however, have only gained 17%. Underperforming the wider materials index. If fundamentals for all miners are improving because of higher metals prices, why are the smaller companies not moving? One explanation is that large investors tend to stick to large-cap stocks that have the liquidity they need in order to enter and exit positions easily. The mining sector thus looks like it is receiving large amounts of speculative investment dollars, which are being funneled disproportionately into the large-cap producers.
This is all positive for mining companies as long as the trend stays in motion. But once the upward movement stalls (which base metals prices seem to have the last couple of days), investment money can start exiting the market as quickly as it entered. Leading to a waterfall of selling, and quick downward price movements. This is the price we pay when investment becomes decoupled from analysis of the underlying fundamentals.