Are resource stocks good value?
What share-price charts tell us about Rio, BHP, Fortescue and Woodside.
Calendar 2016 was a great year for owning resource stocks … BHP Billiton, Rio Tinto, Fortescue and Woodside Petroleum. Fortescue was a standout as it rose from under $2 in January 2016 to $7 by February 2017, a proportional increase of 250 per cent. Then its trend stopped as abruptly as it had started.
So, what happened to resource stocks? The reality is that all trends end, but when and why? In the case of our resource stocks it is not such a hard question to answer. It was a simple case of bigger trends running into smaller trends.
There is a simple charting rule of thumb that says a bigger trend beats a smaller trend. Or more precisely, a longer-term trend beats a shorter-term trend.
That is quite logical when you think about it as the longer a trend persists, the more energy (read: money) goes into supporting it. You could think of it as a wave coming into the beach, building up energy until it finally rolls over and crashes. But before it crashes, if you see a bigger wave intersect with a smaller one, inevitably the smaller one gets swallowed up.
Price trends behave in the same manner. Let us look at our first chart below, for Rio Tinto. This is a monthly chart that goes all the way back to 2010. You can see the 2016 trend in Rio in the context of the much larger downward sloping channel that originated in 2010.
Now, the reason for this trend suddenly ending is a lot more obvious. When drawing these channels, a chartist will start with a supportive trendline (the lower line) using at least two price points. Then you draw a parallel line and move it vertically up the chart, and you should find an obvious price channel will emerge. So, it is with Rio’s bigger brother, BHP.
When viewed in this way the recent reversal in these leading resource stocks appears obvious and it does not bode well for their short-term future either, as they will probably follow the long-term channel down. This is not a good look for Rio and BHP, but it is a slightly different story for Fortescue, which is trading in a wide sideways channel.
Whether the channel is sideways or down does not make a lot of difference once you have reached the top. Generally, you find that a share’s price will reverse and so it pays to at least take profit at this point – if you can recognise it. And in the case of Woodside Petroleum, it would not have been as obvious as the other three stocks.
With Woodside, we see another charting phenomenon that is, unfortunately, far less predictable than when price activity reaches the extremes of a channel – a reversal at the midway point.
Chartists will often include a centre line when drawing price channels so they can watch for reversals at this point. If we see weakness as a market approaches the centre of a channel it is often prudent to take some profit.
Getting technical, the chart patterns seen when we analyse financial instruments are said to be fractal. This was observed decades ago by Ralph Elliott, of Elliott Wave fame, and Benoit Mandelbrot, a renowned mathematician who created the term fractal. It means that very similar patterns occur at different levels of magnification, or are nested. In other words, we see trends within trends, and that’s exactly what we are seeing in resource stocks.
Elliott went on to claim that this phenomenon was the answer to life, the universe and everything, and published a set of rules by which we could supposedly quantify and predict trends. Elliott Wave theory still has a large following today but many chartists consider his work to be largely a curiosity and has little practical application.
Thus, we tend to observe Elliott Waves after they have occurred but can rarely predict or anticipate them in real time.
On the other hand, Benoit Mandelbrot simply stated that he observed self-repeating patterns in financial markets at different magnifications, and this was a strong indication that they were chaotic to some degree. He went on to publish books on fractal geometry that could only be understood by other mathematicians.
Now to another form of nested behaviour, where the resource sector does not actually have a mind of its own as it is very much subject to external influences. The actions of stocks are largely dependent on international commodity prices. So, it is no surprise that when you take a look at the longer-term charts of the common base metals, they all look very similar to the charts of our larger resource stocks.
And in their turn, commodity prices are subject to the prosperity (or lack thereof) of the global economy. Hence the price of iron ore in recent times has been driven by the level of construction in China. And China has shifted its focus away from urban expansion, which means it does not need lots of steel and this has a direct impact on iron ore producers.
This clearly implies that we cannot analyse resource stocks in isolation from international commodity prices, nor the global business cycle. At some point resource stocks will rally again and I suggest that if you want to catch the next trend in a timely manner, you had better keep an eye on these other factors as well.
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