Has the Iron Ore Rally Finally Peaked?

It was back to the red for Australian shares on Friday.

The S&P/ASX 200 (ASX: XJO) dropped by 0.7%, bringing its three-day winning streak to a halt.

Disappointing earnings results from Microsoft and Alphabet (Google’s parent-company) in the United States played a role, as did a drop in oil prices…

Following a sharp rally in recent months, the resource looked vulnerable after an agreement between the world’s biggest producers to freeze output fell flat.

What that means for the resource is still unclear…

For now, Brent crude has remained somewhat resilient at around US$45 a barrel but some economists are still convinced its recent rally could be dampened…

More on the commodities market in a moment…

But first, investors are probably wondering whether Friday’s selloff is something to be concerned about.

For most investors, the answer is no…

Although investing in the share market has historically been one of the greatest ways to grow your wealth, the market itself never goes up in a straight line.

Shares will rise, and they will fall. Following the day-to-day movements of the market and trying to ascertain what they mean would drive you crazy, so it’s best to just focus on the longer-term.

As the legendary investor Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

A warning sign?

In saying that, Friday’s decline could come as a warning sign for some investors.

Shareholders of mining shares such as BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) have watched their shares skyrocket in recent times.

Both have benefited from the rebounding iron ore price, which peaked above US$70 a tonne last week after slipping to a low of around US$38 in December.

BHP has also soared on the back of climbing oil prices.

The resource is now fetching more than US$44 a barrel, after sliding below US$30 earlier this year.

But despite this trend, shares of both companies led the selloff on Friday…

BHP dropped 3.3% and Fortescue fell 7.2%, while South32 Ltd (ASX: S32) and Rio Tinto Limited (ASX: RIO) also ended the session considerably lower.

Maybe we can put it down to the typical day-to-day movements of the share market…

After all, profit-taking is a natural reaction of some investors after a sustained run-up in prices.

On the other hand, maybe it was a sign of what is to come for the sector as a whole.

You see, when iron ore and oil prices hit their respective lows in December and February, most analysts thought they would continue to fall.

Instead, they have taken the market by complete surprise, leading to the sharp rebounds in the shares of those companies mentioned above.

But the fundamentals in both industries are still weak and arguably do not support the uplift in prices.

Consider this regarding iron ore from UBS commodities analyst Daniel Morgan. As quoted by The Sydney Morning Herald, he said (my emphasis):

I do not think $US70 (a tonne) is a sustainable price for this year, nobody expects $US70 to be maintained.

Executives from both BHP and Rio Tinto tend to agree, while analysts from Goldman Sachs think the iron ore price could drop to just US$35 a tonne by the end of the year.

The commodity peaked above US$70 a tonne late last week, but has since fallen to US$66.07 a tonne, according to data from The Metal Bulletin.

Whether this marks the beginning of the downturn is still unclear, but investing in the resources sector today would certainly seem like a risky proposition.

Approach with caution…

Successful long-term investing is as much about avoiding big losers as it is finding big winners.

Investors should always be careful about investing their hard-earned money in places with unfavourable risk vs. reward trade-offs, and that is what I think is happening in the resources sector right now.

Rising iron ore and oil prices have taken the market by complete surprise, and that has been reflected in share prices across the sector.

Investors who got in early have been well-rewarded, but it has also created something of a trap for those watching from the sidelines…

You are right to be cautious…

Cautious of assuming that commodity prices have found a bottom, and will only rise from here…

Cautious of getting caught up in the momentum of the sector as a whole…

And cautious of potentially buying in at the top.

Of course, that isn’t to say investors should flee from the sector en masse

But it is a suggestion that there may be better opportunities out there with what I believe are greater long-term prospects.

These could generate even greater gains without that same level of risk.

One company that I believe deserves a closer look is aftermarket automotive parts distributor Burson Group Ltd (ASX: BAP) – soon to be named Bapcor.

This company distributes the parts to mechanics for the servicing and repair of older vehicles, which consumers typically hold onto for longer during times of economic uncertainty.

At the same time, it is growing both organically and by acquisition, and finding plenty of ways to generate value from its acquisition of Metcash Limited’s (ASX: MTS) automotive division in 2015.

In other words, it’s a defensive play with plenty of growth opportunities.

For the sake of full disclosure, I will note that Burson Group is one of the biggest holdings in my own portfolio, and also a holding of The Motley Fool Australia.

And although the shares aren’t necessarily cheap, I do believe they represent a great long-term holding.

Indeed, Burson Group is just one of the company names you’ll find on the scorecard when you join Motley Fool Share Advisor

Led by Scott Phillips, the service looks for the shares offering the greatest value for investors each month.

And notably, not one of the Australian miners has made it as a recommendation thus far.

That doesn’t mean they never will, but right now, Scott simply believes there are far greater opportunities elsewhere.

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Motley Fool employee Ryan Newman owns shares of Burson Group. The Motley Fool Australia owns shares of Burson Group. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Alphabet (A shares), Alphabet (C shares), and Microsoft.

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