The mining sector gave investors a wild ride in recent years. Last week's price drops triggered by China's surprise interest rate hike were merely the latest in a long series of massive price swings, up as well as down.
No matter what the sector, it is difficult to make logical and intelligent long-term investment decisions in the midst of blaring newspaper headlines and massive price swings. Mining is no exception. Fortunately, history often provides some useful guidelines in such circumstances.
It is not common knowledge but mining shares reached their last significant low point on September 1, 1998. That bottom occurred in the midst of a world-wide financial crisis triggered by the collapse of the Long-Term Capital Management (LTCM) hedge fund, Russia's bond payment default, and worries about Argentina's lack of fiscal discipline.
Miners bottomed out one month before the rest of the stock market and have out-performed the rest of the UK stock market ever since.
A £1,000 investment on September 1, 1998 in the FTSE-Mining index tripled in the last six years and is now worth more than £3,000. The same investment in the FTSE-All Shares index is currently valued a bit under £1,000.
If conventional wisdom is any guide, these gains should not have occurred. Mining shares typically do not perform well when inflation is low or the world economy is growing slowly like it has been doing since 2000. Put the two together and the result should be lethal.
But sector shares confounded the experts this time around. The main reason is the huge economic expansion taking pace in China. Raw materials of every type have been pouring into the country in ever-growing quantities. With little expansion of mining capacity in recent years, the sudden surge of orders created shortages and boosted prices/profits.
Looking Ahead
If some sector boosters are to be believed, this rally has further to go, despite China's on-going effort to slow down its blistering growth rate. A recent article in the weekend press spoke of a 10-year long bull run that is currently underway in the commodities sector.
Unfortunately, the share price advance suddenly ran out of steam just as the article was published. After peaking on October 7, shares fell almost 10 per cent in the next two week. Another four per cent was lopped of the average share in this sector on the day China announced its interest rate rise. It brings to mind the age-old investment question: Is this dip a temporary event or is the rally of 1998-2004 a thing of the past, despite the claims of sector boosters?
Obviously, no one knows the answer to this question with complete certainty. But our graph of the price trend since 1998 provides a useful perspective.
Volatility
Most important of all, notice how volatile this sector is. Despite the overall long-term gain of the last six years, the FTSE-Mining index provided UK investors with a wild ride along the way.
Prices almost tripled in just 16 months after 1998's summer sell-off, quite a healthy rally even by Technology Bubble standards of 1999. The start of the new millennium proved to be pay back time. Mining shares lost almost half of their value in just three months. In the next two years, the sector experienced two additional strong rallies and two more painful retractions.
The bottom line: this sector is not for the faint-hearted. Do not jump into Mining too quickly without first indulging in a healthy round of soul-searching about your risk tolerance.
Support and Resistance
The graph helps to explain why sector shares are a technical analyst's dream. Prices have been steadily fluctuating between well-defined support and resistance lines, the two dotted red lines on our graph.
Shares currently sit less than 15 per cent from the top of the multi-year long trading channel. In many categories, this is a very big gap. For a volatile sector like mining, it is a less meaningful amount.
Given the poor news flow in recent days, and the proximity of current prices to the top of the channel, one must wonder if the sector will be able to a) return to the top of the channel and b) break out to the up-side. Note that the last five attempts to penetrate the top of the channel failed.
The support and resistance lines shown on the graph hint that keeping to the sidelines is a low-risk strategy for the moment.
200-day moving average
The graph also demonstrates the importance of the 200-day moving average which is the average of the last 200 daily closing prices. It is the solid red line on our graph.
Notice the interaction between the current price and the 200-day trend line. Advances often approach the 200-day trend and then reverse. By the same token, declines often run out of steam when they approach the line and begin to rise.
Most interesting of all are the occasional penetrations of the line, up or down. History teaches us that decisive penetrations of the 200-day trend line are typically followed by huge continuation moves.
The 200-day is not a perfect indictor. When it comes to the stock market, no such indicator exists. Even so, it is an important issue worth monitoring given that sector shares are currently approaching the 200-day.
Considering all of the economic and technical analysis information currently available, the best course of action for longer-term investors is to ignore the headlines and keep to the sidelines for the moment. Wait for the current price trend to tip off the long-term direction of this volatile sector. While waiting, use the time to do research on various sector companies.
Go to www:Londonstockexchange.com/engb/pricesnews/statistics/listcompanies/
for a full list of sector companies.