A welcome rally does not a rebound make

Too far. Too fast. That's the obvious conclusion after the remarkable rise and fall of resource stocks this week, but before dismissing what happened as another reason to avoid the sector there is evidence of a positive trend emerging.

Why the market for leading mining stocks such as BHP Billiton and Rio Tinto rocketed, then crashed, appears to have been the result of short-sellers covering exposed positions combined with a stampede by speculators who have seen the signs of recovery, believed that a rise in Chinese demand is sustainable, and don't want to miss out.

The net result has been a wild ride of the sort seen whenever a market is struggling to find fair value or when a move in one direction starts to reverse.

More of the same can be expected over the rest of the year as investors struggle to make sense of conflicting data with the safest strategy being to watch and wait as sentiment drives the mining and oil market one way, and then the other – sometimes in the same day.

Negative factors are easy to see, with the most obvious being that the global economy is not growing fast enough to absorb commodity stockpiles of metals (and oil) left over from the boom, and production cutbacks have been too slow and too small.

The commodity glut and signs of a re-emerging financial crisis in Europe (best demonstrated by the bizarre drift into negative interest rates) makes the remarkable 10 per cent moves up and down by BHP Billiton and Rio Tinto over the past few days difficult to explain, except to see them being influenced by short-sellers being forced to buy back at any price to avoid a financial disaster.

Once the “shorters” started driving prices up with their frantic buying a wave of speculators joined the game only to find that they had bought into an unsustainable rally with many likely to suffer heavy losses.

What is not fully understood is why the short sellers panicked.

One explanation is that the Chinese Government appears confident that its economy will continue to grow strongly – not that there is much new in that sort of propaganda out of Beijing.

Unfortunately, the news out of China is not as encouraging as some people believe. A rise in commodity buying orders from China can be explained by factories re-stocking after the Chinese New Year shutdown, an event which will soon pass.

Another, even less plausible but more amusing explanation, is that the iron ore price was pushed up sharply because Chinese steel mills were restocking ahead of a shutdown of polluting industries in Hebei province to improve air quality for a major horticultural exhibition – a sort of flashback to 1960s style “flower power”.

My explanation is that the groundwork for a cutback in commodity supply has been laid with mine closures, limited new project development and a sharp contraction in exploration, all steps which will eventually see shortages emerge in most minerals, metals, oil and gas – but not as quickly as some people seem to believe.

It will be months and possibly years before the cutbacks have an effect on supply and that assumes demand remains relatively strong – which it isn't.

Early signs of what I regard as an inevitable recovery include a 25 per cent rise in the price of zinc and tin since the start of the year. Both metals have relatively small markets but both lie at the heart of industrial production and both have seen heavier supply cuts than more commonly used metals such as copper and aluminium.

The price moves by smaller metals can be seen as a precursor to what lies ahead, though getting to the stage of a widespread recovery will take time and produce regular peaks and troughs.

Three other factors in the equation have added to a belief that the worst of the commodities crash is over and the next direction for the mining market is up.

The first is the strong revival in gold, a topic Eureka Report has been the leading commentator (to read more, click here). Fat profits being made in stocks such as Northern Star, St Barbara, Regis and Evolution have emboldened speculators into believing that what's good for gold should soon be good for the rest of the sector.

The second factor is a largely unnoticed revival among mid-tier mining stocks such as South32, Iluka, and OZ Minerals, which were moving higher long before the two leaders of Australian resources, BHP Billiton a Rio Tinto took off.

Thirdly, there are signs of life returning to the thinly-traded small end of the resources sectors occupied by mining and exploration stocks with few assets (and less cash) but a place where speculators can make a quick killing if they can get in and get out quickly.

The influence of gold on mining-market sentiment is a two-edged sword. On the positive side there are a large number of Australian-listed gold miners and just as many producing gold as a by-product (OZ and Sandfire for example).

The mid-tier moves can be explained by a number of miners being better managed than the top two. South32 and Iluka, for example, are exposed to relatively weak commodities but both are also debt free, or will be by the end of the year, a far healthier position than BHP Billiton and Rio Tinto which remain burdened by high levels of debt.

Among the small stocks, which are lightly researched by investment banks, and rarely reported in the daily news media, there is a long list of companies which have recently traded up to 52-week share price highs, driven almost entirely by speculators hoping for a “trickle down” recovery.

In some cases spectacular profits can be generated, albeit at the risk of losing everything if other buyers do not join the game – a sort of mining market Ponzi scheme.

An example of what's happening includes a strong move by lithium producer Galaxy Resources which has doubled since the start of the year, rising from 12c to 24.5c during Tuesday trade, before easy back to close at 22.5c – but re-starting its rise today even as the rest of the mining sector fell.

Anova, which is planning to develop a gold project in the US, has almost doubled this year, rising from 4c to 7.5c. Plymouth Minerals, which is exploring for potash in Africa, is another stock that has doubled this year, rising from 6c to 12c.

While tiny exploration stocks do not have investment credentials they are a useful pointer to the changing sentiment in the mining market, which, after four years heading down is now trying to find a way up.

For genuine investors (rather than speculators) now is a time to start brushing up on the resources sector, but don't rush in because while fast profits can be made there are pitfalls ahead before a sustainable recovery takes hold.