Find below a trade idea offered in Macro Investor seven weeks ago, one of many ways of profiting from the end of the mining boom we’ve discussed in the past several months. This is why it pays to have a forward looking investment newsletter in your corner. A 21 day free trial is available at the Macro Investor website.
In recent months, the economic fundamentals of China’s fixed-asset led boom have faltered, bringing down both sentiment and expectations. The decelerating growth rates reflected in lower prices for key commodities such as iron ore and coking coal, Australia’s terms-of-trade position has also suffered, as have local markets across the region.
As uncertainty also continues about a credit crunch emanating from a European break-up or sovereign debt disaster in Spain and as new supply from Africa and South America comes online, Australian mining companies are understandably nervous, cancelling or delaying project starts where previously they were bullish. This has been reflected in mining company shares and, to a small extent, the Australian Dollar, but mining services firms, which stand the most to gain and lose from the status of mining construction projects, are still in many cases riding high. We expect recent falls in bulk commodity prices to flow through to material capex retrenchment in medium term.
Yet with China entering a period of political transition at a time when social unrest is arguably at a post-1989 high and global disinflation is driving down asset values, Beijing and regional government’s have begun to roll out staged stimulus packages which can be expected to continue.
Of course, the size, timing and composition of potential stimulus is unknown and as such we are advocating a hedged pair trade, not a full-blown directional one despite the now attractive valuations of many mining companies. By having a foot in both the bearish and bullish camps on commodities and China we aim to capture returns from the slowing in mining investment plans, as well as hedging China’s medium term stimulus.
Trade Entry and Stop Loss
Based on a technical set up, the trade portfolio would go long BHP, Australia’s biggest and arguably strongest diversified mining company, and short SXE, a small and low-margin engineering services firm. This trade would use a weighted strategy on a breakout up or down respectively, and weighted according to the moves in the spot iron ore price (Tianjin), as well as the two companies’ fundamentals.
BHP is currently in a well established bear market condition. Its price is hovering just above the support level of its GFC low, near $30 (and the obvious stop loss level), and it is considerably oversold at these levels. A long entry would require a substantial rebound and follow-through of short term resistance at $32.65 and the 200 day moving average level at $34 respectively:
Southern Cross Electrical (SXE) is in a very different market condition. Having undergone a serious correction throughout most of 2011, the stock almost doubled from its lows during the European-led rally post-Christmas. The stock is now in a consolidation pattern with support at $1.10 per share and resistance at $1.30, and remains above its 200-day moving average. A short trigger would be enacted on break of support, with a likely stop loss at $1.20, then confirmed by a secondary directional indicator:
For iron ore, the spot price (USD per metric tonne) is heading for the critical support level at $116:
Trigger – not yet initiated
The trade is not yet initiated through a technical long or short for either side of the pair. The price of BHP is still falling and although the price SXE remains elevated, it is starting to slip.
Position and Capital Management
Given the extreme volatility of the commodities market in general, we consider a total equity at risk for this trade strategy of 1% to be prudent. When positions are opened, they will be adjusted according to this level, with initial positions likely to be in the 0.25% to 0.5% range of equity at risk for each.
Because of the need to use contracts for difference (CFD’) this strategy cannot be implemented via the MacroGrowth portfolio, and will instead be included in the MacroTrades portfolio.
Risk/Reward Analysis
The risk/reward for this trade is difficult to assess, but a calculation of likely price targets if BHP breaks to the upside and SXE to the downside, offers a starting point.
For BHP, an initial price target of $34 makes sense because it was the former support level before May this year. The next price target would be $39 per share, the pre-QE2 price from 2010. With an initial stop loss level at $30, an initial position opened at $32.65 would equate to a risk/reward ratio below 1:1 which would be undesirable. Hence the higher target would be required for a larger position, at a ratio of approximately 2.4:1.
For SXE, the price target could be as low as 70 to 80 cents, or the pre 2011-Christmas rally. With an initial stop loss at $1.20, if the stock were to break below the $1.10 barrier this would also equate to a 3:1 risk/reward ratio. If both targets are met, this paired trade could provide up to 3% in positive performance.
The bottom line: This macro-based pair trade could provide a positive return of up to 3% to the trading portfolio if successful.
Disclaimer: The content on this blog should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation, no matter how much it seems to make sense, to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The authors have no position in any company or advertiser reference unless explicitly specified. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult someone who claims to have a qualification before making any investment decisions. Macro Associates is a registered representative of BBN Capital Pty Ltd, ABN 84 099 000 389, AFSL 313768.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
Southern Cross Electrical (SXE) is in a very different market condition. Having undergone a serious correction throughout most of 2011, the stock almost doubled from its lows during the European-led rally post-Christmas. The stock is now in a consolidation pattern with support at $1.10 per share and resistance at $1.30, and remains above its 200-day moving average. A short trigger would be enacted on break of support, with a likely stop loss at $1.20, then confirmed by a secondary directional indicator:
