Yesterday's news that China is looking to rein in its property market was the catalyst for a selloff in Australian resource stocks.

The iron ore price could be affected and the chart is showing early signs of a bearish double top. I've posted some thoughts on the technical outlook for both iron ore and Rio and the relationship between the two.

Iron Ore

There's not room here for a full discussion on what drives iron ore prices. This is a list of things that have recently caught my attention

  • Iron ore prices are usually stronger in the first half of the year
  • Changes in inventory by Chinese steel mills and traders have become a significant source of volatility in the iron ore market
  • The recovery in prices over recent months appears at least partly driven by a build up in Chinese inventory before the New Year and as a precaution against weather related supply disruptions over the Australian summer
  • The property market has been a key driver of growth in China's steel demand in recent years
  • The consensus view appears to be that iron ore prices are likely to weaken in the 2nd half of 2013 as China winds back its stimulus program and housing market.

Iron Ore 62% Fines Tianjin. Source; Bloomberg Iron Ore 62% Fines Tianjin. Source; Bloomberg

The chart above shows iron ore prices landed at China's Tianjin port. This is the figure that's now widely quoted in the press.

My observations on this chart are:

  • A break under $145 support would complete a bearish double top (there seem to be a lot of these around at the moment)
  • There is quite significant support between 123 and 127. This consists of the November peak; the 200 day moving average and 78.6% retracement of the last swing higher
  • A break under the double top support may see a correction of the last upswing. This could produce  a move back towards $123
  • A break below (overlap through) $123 could be a long term bearish development.

Iron Ore and Rio

Rio is at the moment largely an iron ore company. Its last report showed 81% of total Earnings before interest and tax (EBIT) coming from iron ore

RIO V Iron Ore Index. Source: Bloomberg RIO V Iron Ore Index. Source: Bloomberg

The chart above plots the daily price of Rio against iron ore.  Although there is obviously a loose relationship, from a statistical point of view the short term correlation is surprisingly weak

Some factors to consider in the correlation between mining stocks and the commodities are:

  • Theoretically mining stocks are valued on the basis of the value of all the metal they own under the ground less the cost of getting it out of the ground and selling it. In other words valuations are supposed to be about long term prices not just the next few weeks or months
  • Most long term analysis already factors in a significant drop in iron ore prices as supply increases
  • Mining company valuations involve the cost and risks of their operations including political and financial risks as well as just the price of the commodity they sell
  • Many investors are expecting capital management initiatives from the big miners - higher dividends or buy backs now that they have changed to more conservative management. This could be an ongoing positive for stock prices

Rio Chart

Weekly

RIO CFD - Weekly. Source: CMC Tracker RIO CFD - Weekly. Source: CMC Tracker

The short term trend here is lower and the stochastic is falling sharply. This indicates strong downward momentum and suggests a strategy of selling rallies for short term traders

Daily Chart

RIO CFD Daily. Source: CMC Tracker RIO CFD Daily. Source: CMC Tracker

  • The daily chart has significant support around $58/60. This is equivalent to the $123/127 zone for iron ore
  • For medium term traders, any basing pattern above $58 could be an opportunity to buy after a correction looking for the 5th swing higher in a medium term up trend
  • Overlap below $58, is potentially long term bearish. A move below the $58 peak may indicate that the long term downtrend has resumed.