Economic growth in China is a major factor for global growth. It is not an understatement to suggest that if the Chinese economy growth was to contract further this year, equity markets in the U.S. and Europe would decline significantly. As the world’s largest commodity consumer, China’s economic performance is especially important for commodity and industrial stocks.
This is precisely where the market ran into a snag over the weekend. China’s finance minister said that the government has no plans to change current monetary/fiscal programs. That dashed hopes that China may increase its current easing initiative beyond the current programs. Commodities dropped, with base-metals like copper declining to long-term support, following the news.
The question at this point is whether China will engage in an enhanced stimulus program anyway? Does the Chinese government ever send mixed signals to the market like this? Have they denied stimulus programs in the past and then launched new programs anyway? Does a bear… you know… in the woods? In our opinion, the likely answer to all of these questions is yes.
The Chinese economy is between a rock and a hard place. It is sitting on 375 million square feet of vacant new real estate development. Loans dished out in prior stimulus programs have a projected default rate of 20% and the global economy still hasn’t really taken off yet – especially in Europe. China really has no choice but to keep spending while it waits for market conditions to improve. If it does nothing, it risks instability that could re-initiate the civil unrest and inflation we have seen recently.
We can (and should) debate the risks of this kind of government intervention, but we should also consider the likely effects of a new stimulus program on commodity stocks. Regardless of our individual political biases, there is probably some money to be made in the short term if/when China launches another infrastructure or loan-based economic program this year.
Our choice for this opportunity are steel stocks – specifically, the mini-mills. The Chinese economy needs steel and new projects will drive up the metal’s price globally. Nucor Steel (NUE) looks very interesting from this perspective. Technically, the stock just broke out of a long-term symmetrical triangle and still has room to move to the upside. The stock gave up some of its recent gains after bad news was released in China last week but we think it will fill its gap, and bounce at support.
Nucor Steel (NUE): Chart Courtesy of eSignal
As you can see in the chart above, the stock gapped higher on Sept. 17 following new, better than expected guidance for the year. However, “bad news” about the Chinese economy initiated some profit-taking and the stock looks likely to fill the gap just under $56 per share. This is almost the inverse of the bearish dead cat bounce pattern and can be just as predictive to the upside.
The fundamental catalysts for this move depend on China doing what it said it won’t. However, that isn’t much of a stretch since that has been their modus operandi over the last several years. To be clear, it’s not a guarantee that they will do it this time as well, but it seems very likely. We suggest a staged approach to this trade.
Assuming support isn’t broken, buying NUE following a bounce off support at $56 looks attractive. However, we would suggest monitoring the high at $58 for signs of resistance. A break above that level would be a good opportunity to add to the long position.
NUE reports earnings the middle of next month. Unfortunately, it is the first of its peer group to report so we won’t likely have any early warnings that there is trouble. However, this may also present an opportunity to salvage the trade if things go bad. We like NUE because they have been a fundamental leader in their group. If the report misses expectations, the stock will drop and the trade will likely be at a loss, but the unprofitable companies within their group like AK Steel (AKS), Schnitzer Steel (SCHN), and United States Steel (X) should start to drop even more.
Stopping the NUE trade and reversing into a short position in one of these struggling peers could do a lot to minimize the losses and even walk away with profits in the worst case scenario. Option traders may even want to consider an option hedge against a long position in NUE. Protective puts are going to be expensive, but the potential upside should justify the expense. The more effective coverage to the downside following an unexpectedly bad earnings release would be a real asset if China has really done the unexpected and said what they really mean.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
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