Resource Sector Prices: Worth the hype? | BetaShares

Resource Sector Prices: Worth the hype?

BY David Bassanese | 26 April 2016
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Along with the rebound in the Australian dollar and commodity prices, prices within the materials sector of the Australian equity markets have lifted strongly in recent months.  Indeed, the rise has come despite continued declines in forward earnings, with the result being that the sector’s price-to-earnings valuation is now at well above long run-average levels.  As this note demonstrates, while high valuations do not necessarily suggest sector prices can’t rise further from here, it would require a relatively heroic rebound in commodity prices.

 

The materials sector has enjoyed good price gains in recent months.  Since bottoming on February 3, the S&P/ASX 200 Materials sector (largely comprising major mining stocks) has lifted by around 37% by the end of last week.  The rebound has clearly reflected the strong rebound in iron ore prices and improved sentiment regarding the Chinese economy.  Of course this begs the question: has too much good news already been priced into the market.

As seen in the chart below, based on current sector forward earnings by end-April, the sector was trading at a price-to-forward earnings ratio of around 23.5, which is well above its long-run average of 13.1. Indeed, sector valuations are now even higher than at the previous valuation peak of 20 times forward earnings in mid-2009.  As it turned out, sector prices back then were still able to rise by a reasonable 8% over the year to mid-2010, though only because of a fierce rebound in forward earnings and commodity prices as the global economy recovered from the financial crisis.

mat1
Source: Bloomberg
Indeed, as seen in the the chart below, sector valuations were at a peak in mid-2009 at precisely the time that commodity prices and forward earnings were wallowing at their GFC inspired lows. The subsequent rebound in commodity prices over 2009-10 helped drive sector prices higher, even though the forward PE ratio collapsed by 45% (from 20.1 to 10.9).
mat2
Source: Bloomberg
Of course, if commodity prices rebound in the coming financial year as smartly as they did in 2009-10, then the current surge in mining stocks and valuations is largely justified (though, even here, most of the gains already seem behind us).  Given the current global backdrop of relatively subdued demand and ample global supply, however, it remains doubtful that we will see a sustained rebound in commodity prices anywhere near that evident following the GFC. At best, it seems more likely that commodity prices will broadly bottom out and trade in a range in the coming year, in which case materials sector forward earnings could flatten out rather than fall further. In this case, however, the sector is still left with sky-high valuations to digest.
All up, the optimism that has been priced into the resources sector in recent months seems a little stretched. It’s one of the major reasons why it seems likely that the Australian equity market will struggle to post solid gains in earnings and prices over the coming year.

2 Comments

  1. Thanks David very useful information.

    Just a question when BHP and RIO took off from 2003 the forward P/E was trending down into 2008. Presumably price rallied strongly ahead of earnings growth. I gather the data is not available for the period prior to 2003.

    Seeing as volume produced is being absorbed by China (with from what I hear of no discernible stockpiling) are the noises that the producers are making about contracting supply in the face of another price fall just hot air?

    PS I am interested that you and Goldman Sachs and the Producers seem to be on the same page about lower Iron Ore prices soon. Is that normal?

    1. Jeremy Benson  |  May 30, 2018

      Hi David,

      Thanks for your enquiry and I apologise for the delayed reply. Just very quickly, obviously a lot has changed since this article, but David’s view on iron ore was in-line with the consensus view at the time, and still generally stands today (the Australian government has modelled lower iron ore/resources prices over the next couple of years in the most recent budget).

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