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The Credit Suisse research team has become so bearish on the resource space that its latest commodity price forecast report is titled "The setting of the sun." One of the foundations of CS' pessimistic outlook is the current relationship between global mining stock earnings and commodity prices. Applying this theory to domestic mining companies, we find a situation less dire, but still disturbing.
In the report, global equity strategist Andrew Garthwaite presents a chart highlighting forward earnings estimates for global mining stocks with commodity prices. The comparison clearly shows that earnings are trailing spot prices. Mr. Garthwaite draws two conclusions from this: that mining stocks are now less efficient – generating less profit at each commodity price level; and that earnings estimates in the mining sector are set to fall sharply.
We did the same analysis for the domestic S&P/TSX Diversified Mining Index (see chart). Thankfully, the disparity between spot prices and forward earnings estimates is smaller than the global average – Canadian miners have been better at maintaining profit margins than their competition.
The results of our research, however, are not entirely positive. The chart provides evidence that earnings estimates trail movements in commodity prices (the early moves by the GSCI Industrial Metals Index on either side of the financial crisis are pretty much definitive in this regard).
Analysts have a habit of jacking up earnings estimates every January, and 2013 was no different. But this year, commodity prices have headed straight south, moving against analysts' early year optimism. Estimates have not yet fully adjusted to lower metals prices (remember that spot prices lead estimates). When they do, stocks in the sector will likely get hit again, barring a sharp rebound in copper, iron ore, zinc and other metal price levels.
Investors in Canadian mining stocks should be cautious, but this isn't necessarily a sell signal. It has often been the case that reduced analyst profit estimates mark a capitulation in the sector that sees stocks form a bottom, which comes in advance of a move higher.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow