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What Happens to Stock Price when Metal Price Fall?A How To Book Of Self Managed Super FundsThe Greens Super PolicyEmail Marketing For Planners
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What Happens to Stock Price when Metal Price Fall?

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

When commodity prices fall, the prices of mining stocks are likely to go down, too, according to conventional wisdom. Historical outcomes have not been so clear-cut.

The accompanying chart shows the ASX 200 Resources index (blue line) and the International Monetary Fund metal price index (red line) between the early stages of the current cycle and the end of January 2011.The inference from this chart seems clear-cut: if we know what will happen to metal prices, we will know the direction of equity prices.

If, as most analysts suspect, we are near or just past a peak in commodity prices, the relationship portrayed in the chart implies investors should steer clear of resource sector equities.

There is, however, a danger in embracing this conclusion too readily. The near term correlation between equity prices and commodity prices shown in the chart is not typical of the relationship.

The history of earlier cycles offers a markedly different picture of how equity prices might react to a cyclical readjustment in commodity prices.

There have been four cyclical peaks in metal prices since 1970: May 1974, February 1980, June 1988 and January 1995. The average time to elapse from the peak price to the subsequent price trough was 3.4 years. The average fall in prices was 43%. The smallest fall was 28% and the largest 57%.

Despite the magnitudes of the metal price falls, Australian resource sector equity prices - measured by the major resource sector equity price index in use at the time - actually rose in two of these four periods (after the 1974 and 1988 price peaks) and the average equity price decline as commodity prices were moving from peak to trough was only 1%.

These surprisingly strong resource sector equity performances in the face of clear cyclical reversals in commodity prices could have been due to a broader strength in equity markets. Research has shown that the prices of commodity related equities bear a closer relationship to the equity markets in which the companies are listed than to movements in the prices of the commodities produced by the companies.

Adjusting for Australian equity market conditions (i.e. measuring the extent to which the Australian resources sector outperformed the broader Australian equity market), the stock market outcome is slightly better aligned with metal price moves. The resources sector underperformed the broader market by an average of 20%.

Resource sector equity prices still outperformed the broader market in two of the four cycles. The greatest underperformance - 74% - was between 1995 and 1999. Of course, this coincided with the advent of the internet as an investment theme and, to that extent, had some unique characteristics.

In the prior three periods, the average annual underperformance by the resources sector was only 1% and, in two of those three periods, the resources stocks actually outperformed the broader market.

In the current cycle, there does not appear to be anything equivalent to the internet boom to distract investors. That leaves a mixed picture from which to draw conclusions about the likely impact of a cyclical decline in commodity prices. But even that insight could be valuable insofar as it tells us that history does not support the conventional wisdom about how commodity prices might affect equity values. In short:

- cyclical movements in commodity prices have not always precipitated large equity price declines;
- there are examples of positive absolute returns from resource sector equities while commodity prices are in decline; and,
- a 30-50% cyclical fall in metal prices could be consistent with a relative decline in equity prices of as little as 1% a year.

For more analysis and commentary on resource sector investing go to: http://www.eimcapital.com.au/C&A01.htm


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