It is always amusing how dumb the equity market is. Dumb economists and analysts will tell you that the market is always right but that is a misunderstanding of what makes markets useful. The best description of the utility of markets is that they are often wrong but are ruthlessly efficient at correcting mistakes. I can’t recall which Fed president said it.
So, today, how are markets wrong? Iron ore miners as usual. In particular, FMG which is enjoying a nice dead cat bounce:
To illustrate my point, the last time that iron ore traded at $107 was in July of 2020 and 2019. On those two occasions, the stock price was roughly $17 and $9. Can you tell me why the difference?
There is the function of discounting the future to consider. But that doesn’t really work in these examples. In 2019, there was a global shortage of ore as Vale choked on its dams. The future looked rosy.
In 2020, there was still a lot of doubt about how COVID 19 might impact economies. The future was clouded at best.
Some will rightly put the difference down to sentiment. But that’s really just an excuse for anything you can’t explain, which is pretty stupid in itself. Take poor old Jevons Global which is still throwing itself manfully under the iron ore miner bus:
We suggested a clearing price around $100 USD/ton. The futures price hit that level last Friday, and has been testing levels around $90 USD/ton. These are marks that represent the reversal of the market to mid 2020 levels, before the October rally kicked off the bull market.
Our attention should now turn to the stocks themselves: “Where are the stocks of iron ore producers headed? Lately, down, down and then down some more.
This is natural in a sharp retreat for commodity prices. However, BHP Group is not only an iron ore miner. It has metallurgical coal, copper, nickel and oil and gas. Our concern must also be for the valuation of the underlying business, which is discounted future cashflow. That is a judgement on the range and value of future realized prices over time.
Valuations of stocks reflect more than spot values, or indeed the futures curve. They represent an estimation of the likely fair value of continued operations over some years.
So much, so obvious. Value investors are famous for saying “Now is the time to buy, when all is misery and carnage.” This is the thrust of the old exhortation, attributed to Nathan Rothschild, that one should: “Buy when there is blood in the streets.” That is sage investment advice on the vagaries of human psychology, so long as there is not more blood tomorrow.
Flip back to this moment in time, and we can record that the first sign of some pause in the present sell-off happened yesterday. Pauses in a general bear trend are not that unusual and not themselves indicative of an end to a down draft. The issue is investor sentiment.
I don’t think so. The issue is that the macro and micro pictures for iron ore, and the miners that rely almost entirely upon it for profits (BHP is the best at only 80%), are disastrous.
Compared to reality, current equity prices suggest that sentiment is FAR TOO BULLISH, as comparisons to previous downturns and upturns illustrate.
Another dill is Bell Potter:
Overall, we find that FMG is in a strong position to maintain strong margins, earnings and dividends. EBITDA margins remain more than 60% over the forecast period under our new Base Case.
Lower forecast iron ore prices do not impact FMG’s ability to fund its near or medium term capital or debt servicing requirements under a range of scenarios.
While our valuation of FMG is sensitive to our long-term iron ore price assumption (unchanged at US$95 a tonne) bearish near-term scenarios we have run indicate that competitive dividend yields of more than 5%, fully franked under our lowest case look like remaining key supports for the FMG share price at current levels.
This is called “garbage in, garbage out” analysis. If you assume anything you want then you can conclude anything you want.
Don’t get me wrong. If China came out tomorrow with a 1% rate cut, exhortation that houses are for speculating on not living in, approvals for $400bn in infrastructure at the NDRC, suspended the Three Red Lines policy, and liberated steel mills to pump output, I’d buy FMG with both hands.
But that has not happened. Nor does not it look likely before growth and steel demand gets materially worse.
So I will wait and watch while “sentiment” deflates and the iron ore market returns to an underlying reality that is still far below and falling.
