Rust

A while ago I wrote a short article on small cap mining stocks. Now is one of those times where things get interesting and it’s worth taking a closer look.
You may have heard commentary (of varying levels of tedium) declaring the end of the mining boom.
This has picked up with the enormous slide in iron ore:
At this price an estimated 60% of the iron ore industry is operating at a loss.
Unsurprisingly this has had a dramatic effect on the shares of the small and mid cap miners. Ironically, after years and years of development and steady progress, precisely when there’s finally an opportunity to reap rather than sow, the markets have turned. There is every chance those huge investments in increasing mine output will result in enormous losses, if miners have to ship ore at prices substantially below that celebrated $120 ‘floor’. Not that floors ever hold.
The big picture, and a recommendation
 
When the price of a commodity nosedives (or anything really, say, a sector of the mortgage market), when there is no major news or new information – perhaps particularly when there’s no news or information – generally Something Big is Up. The most dramatic cases in recent memory were collapse in isolated sectors of the mortgage and credit markets in 2007 and more recently the April/May oil slide last year.
The market for iron ore is not particularly developed. The price is set by the few major producers and the steel mills who buy it off them. Unlike in, say, crude oil, there is no liquid spot or futures market..
Which completely discredits the usual fulminations that speculators are behind the move. At some level, somewhere, buyers simply aren’t turning up to buy. In this case that would be the Chinese, and considering how dominant their contribution is to global growth, that is a worry.
Meanwhile, implied (and realised) volatility is at lows not seen since 2007, and US stocks are pushing mid term highs.
With about a clear a sign as possible that end demand in China is drastically lower than expected and with the US fiscal cliff and the tense budget negotiations likely to come with it steadily approaching, it would seem that this is a great time to take risk off the table – stocks have had a great run and the upside is certainly at the very least nuanced from here.
In other words, sell your stocks and balance your currency exposure (particularly if you’re holding alot of AUD).
Speculations
 
It never pays to get too scared, so the next step is to figure out how to make money out of the situation. After falls this large in small cap producers, the upside will be huge. But it’s all about the micro.
BHP and RIO will survive almost any scenario due to the quality of their assets – they’ve used their financial power over the past decade to pick up the lowest cost mines. BHP’s decision to curtail production now was absolutely the right one, and RIO is heading for a big shock if they mistakenly see an opportunity to take market share.
There is a great article on Fortescue, the largest pure play iron ore producer in Australia. There is clearly a bull case, but the dust should settle first.
And finally it’s worth taking a look at the small caps. As in my previous article, they’ll provide option-like upside with no carrying cost.
Ironically, while I think it will pay to take most of your risk off the table, taking small positions in an appropriately financed small caps would give you most of the upside while leaving plenty of cash to deploy when things get worse. I’ll take a closer look and see what I can find, but in the meantime, take a look at my previous article.
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