What Rio’s Share Price Is Telling You about China

Dear Reader,

Today’s essay is all about the power of emotion and sentiment. And a virus.

When it comes to stock prices, these forces (emotion and sentiment, that is) play a more significant role than you could imagine.

For example, think of a stock with earnings of $1 per share. It trades for $15 per share. It therefore trades on a P/E (Price-to-Earnings) multiple of 15 times.

This company grows earnings strongly over the next few years. Earnings per share increase to $1.50. Investors wake up to this growth potential. They become excited about the company and price it accordingly. The stock now trades on a bullish P/E of 30 times.

30 times earnings per share of $1.50 = $45. That means our company now trades for $45 per share.

That’s a 200% increase on the $15 per share it traded for previously. While the rise in earnings accounts for 50% of that increase, it’s the P/E expansion that provides the real kicker.

A high P/E reflects the expectation of strong future growth. And in many cases you can justify a high P/E. But another way of saying this is that a high P/E reflects the power of investor confidence in the future. It is an indication of the optimism of the market.

I bring this up because of the potential devastating impact of the coronavirus on China’s economy, and by implication, Australia.

Imagine if this thing broke out at a time of poor market sentiment? It would be sell first, ask questions later.

But in this market, it’s the opposite.

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Put that down to the power of positive sentiment. This bull market has a solid head of steam. Central bankers have underpinned its rise for years.

Right now, the belief in the power of low interest rates is stronger than the fear of a global pandemic.

That tells you a lot about the strength of this bull market. It could also suggest that we’re at that late stage where investors become blind to the risks and continue to go all in.

Judging by the response we received from Vern Gowdie’s recently released special report, urging investors to get out of the market before it’s too late, I feel there are a lot of blind bulls charging around the market.

Let’s just say Vern’s message didn’t go down too well. That’s an interesting contrarian sign for those who like to take note of these things.

Impact of coronavirus on stocks

The impact of the coronavirus is hurting some stocks though. And it could get worse.

In my view, the probability of a devastating outbreak remains low. The issue is that containment promotes inactivity. Inactivity means a continued slowdown in the world’s second largest economy.

You’ll see the most immediate impact on travel related stocks. Qantas Airways Ltd [ASX:QAN] shares are down sharply from their peak. Flight Centre Travel Group Ltd [ASX:FLT] is near a two-year share price low.

That means less punters going to casinos, so you’ll see an impact on the businesses of Crown Resorts Ltd [ASX:CWN] and The Star Entertainment Group Ltd [ASX:SGR].

The education sector is also highly vulnerable. It’s one of Australia’s largest ‘export’ sectors, thanks in part to Chinese students.

Vitamins and supplements producer Blackmores Ltd [ASX:BKL] is in a trading halt.

Commodity stocks are also under pressure, especially oil and gas producers. Chinese importers of LNG have invoked a force majeure clause in their contracts. This means that they do not want to take delivery of previously contracted volumes. They cite the virus as an ‘act of God’ that has impacted demand.

However, some LNG players dispute the claims. From worldoil.com…

SINGAPORE (Bloomberg) — Two of Europe’s biggest energy companies rejected a Chinese force majeure on liquefied natural gas contracts in the latest twist to a drama that’s gripping global commodities markets.

Shell and Total didn’t accept the legal grounds for the move by CNOOC that would have freed it from its contractual obligations to take delivery of the shipments, according to people with knowledge of the matter.

While CNOOC is still likely to cancel delivery of the prompt cargoes, suppliers will probably seek compensation from the Chinese firm, said the people, who asked not to be identified because the matter is private.

CNOOC made the dramatic move as it struggled to take delivery of LNG because of constraints caused by the virus, which include a lockdown of more than 50 million people in more than a dozen cities. It was one of the first known cases of the legal clause being invoked in commodity contracts due to the epidemic, which has plunged raw materials markets into chaos.

Rio’s early warning

If the lockdown across China continues for a few more weeks, you wonder how long it will take for the iron ore market to face similar challenges.

You’re certainly seeing the impact in the price of iron ore major Rio Tinto Ltd [ASX:RIO]. It’s down sharply from its peak of a few weeks ago.

More importantly though, if you look at the chart of RIO below, you’ll notice a concerning development…

The Rum Rebellion

Source: Optuma

[Click to open in a new window]

Note how RIO’s share price rallied back to the peak from July last year and turned down. Meanwhile, the broader market broke out to new all-time highs, surging past the July 2019 high.

In other words, RIO is now underperforming the broader market. Is this a sign that the commodities bull market that got underway in early 2016 is now over?

What implication does that have for the Aussie economy and interest rates?

It’s too early to answer those questions. But it’s worth keeping an eye on this economic/commodity bellwether, along with BHP, for clues on China’s growth.

Bullish, optimistic and complacent investors might not notice these things, but the market will always give you clues and early warnings if you care to look.

I’ll be keeping a close eye on some key stocks in the weeks ahead. It’s important to try and ignore the noise and bullish sentiment, and listen to what the market is really trying to say.


Greg Canavan,
Editor, The Rum Rebellion

PS: Click here to download your free report and learn about the earnings crisis facing Aussie iron ore stocks in 2020…and the mining companies to own instead.

Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.

Learn more about Greg Canavan's Investment Advisory Service.

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