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Should you join these investors jumping back into resources shares?


The Australian Financial Review this morning reported that (my emphasis):

“Local shares are set to open higher to start the week, rebounding from Friday’s losses, amid renewed interest in oil, gold, iron ore and base metals.

The iron ore price rebounded 1.8% during the latest session to US$62.69 a tonne, according to data from The Metal Bulletin. True to The AFR’s word, the BHP Billiton Limited (ASX: BHP) share price has risen 1.4% at the time of writing, while the Fortescue Metals Group Limited (ASX: FMG) share price and Rio Tinto Limited (ASX: RIO) share price are up 3.3% and 2%, respectively.

According to Business Insider, the iron ore rally was sparked by renewed strength in Chinese steel prices, with indications it “may not be over yet.”

Meanwhile, Brent oil rose 2.1% and gold was up 0.7%. Indeed, gold has been particularly shaky in recent times, causing plenty of volatility in the share prices of businesses such as Northern Star Resources Ltd (ASX: NST) and Newcrest Mining Limited (ASX: NCM). The pair have fallen 3.3% and 11.5% over the past month, respectively, but risen 1.4% and 1.2% so far today.

So, with some investors pouring their money back into the sector, the question once again becomes…

Should you join them?

Since the beginning of 2016, shares across the commodity sector have been among the market’s best performers. The BHP share price has risen 36% during that time, with the Newcrest share price rising 61%. Fortescue’s share price has nearly tripled, up 180% in 17 short months, while Whitehaven Coal Ltd (ASX: WHC) has jumped a whopping 270%. Here’s what those returns look like in chart form:

Chart 1. Source: Google Finance

With those kind of returns, it’s easy to see why investors might be tempted – particularly when the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has returned just 8.1%.

But there is something about the resources industry that investors need to consider before investing their hard-earned dollars.

Resource producers rely largely on higher commodity prices for their ongoing growth. Although many have engaged in enormous cost-cutting initiatives (with many doing so successfully), a fall in prices has the potential to significantly reduce their earnings potential with their share prices likely to follow.

Indeed, investors experienced just that during the commodities turn in 2015, with some of the carnage shown in the chart below:

Chart 2. Source: Google Finance

It can be difficult to ignore the gains that have been achieved across the sector since the beginning of 2016. And, with some share prices pulling back even more recently due to a recent decline in commodity prices (iron ore, for instance, was fetching almost US$100 a tonne recently), some investors will no doubt see this as an opportunity to ‘buy in at the bottom’.

But you need to remember that commodity prices may not have bottomed out just yet. That is to say that the latest rebound may also prove temporary which, if true, could hurt those who are buying in today.

Unfortunately, I can’t give you a definitive answer on which way commodity prices will go from here. After all, commodity prices are inherently difficult (if not impossible) to forecast with any consistency. But what I can tell you is this: if you invest in the resources sector, your money is at the mercy of commodity prices, which is something the miners themselves have zero control over.

Although some investors will likely take the most recent rebound as a sign to re-engage with the sector, I would think twice before doing so.

Foolish Takeaway

So, here is my advice. There is every chance commodity prices (and resources stocks) could rise in the short-term, but rather than focusing on the immediate outlook (the coming days and weeks), focus instead on where you think commodity prices will go in the medium- and long-term. If you think commodity prices will decline over that period, it may be a wise idea to remain on the sidelines.

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Motley Fool contributor Ryan Newman has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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