Monday, March 12, 2012

MCP and REE: A Study in Correlation

Last week, we discussed two Rare Earth stocks, Molycorp (NYSE:MCP) and Rare Elements Resources Ltd. (AMEX:REE), and we noted as follows:
MCP actually mines, and has a source of revenue.  In a sense, its $2b+ market cap makes a lot more sense than $REE's market cap that is 10x smaller.  MCP's price action suggests rare earth stocks could have some room to run in 2012, as it has not attempted a run at the top of the channel for a while and is nearing oversold on RSI again after its recent touch of the bottom of the channel.  So if MCP runs, this could give a bit of a boost to REE as well.
And, lo and behold, rare earth stocks have been on somewhat of a tear since we posted that.  Here is a chart of REE and MCP over the past week.

What is interesting is that the two stocks both jumped on Friday, but that MCP is up around 20% on the week whereas REE is up only around 5%.  Looking back over the past months, a similar pattern can be seen.

With the exception of a huge surge in buying in January, REE has tracked MCP but performed noticeably weaker.  We would not be surprised if this were to continue going forward.  Given that MCP has a functioning business and sources of revenue, and REE is an Amex-listed speculative mining play, there is a decent likelihood that, if and when this rare earth madness cools down more, REE will be worth $0 while MCP will still be a decent company.

So what happened?  How did REE even make it this far, and how did it at one point command a market cap of $750m at the height of the madness? 

It's pretty clear what happened: MCP went public.  Before that, REE was trading at about $3 a share and was nothing special.  Once MCP went public, however, REE began to take off along with MCP.  REE simply hung along for the bubble ride in rare earth stocks, which benefited both MCP and REE equally for a while.

It was only in April 2011 that the correlation started to break down, as the realization seemed to dawn on the market (or perhaps short sellers) that the two companies were not exactly identical and perhaps shouldn't trade exactly in lockstep. 

Correlations like this are interesting, and reflect the temporary irrationality of bubble price action.  Being able to sort out legitimate companies from perhaps less legitimate companies is important amidst buying frenzies.  But it is also important amongst selling frenzies.

In a sector we follow closely, Chinese real estate, correlations have pulled all Chinese real estate stocks down to levels where many stocks are trading at a discount to book and extremely low p/e levels.  While as a sector Chinese real estate may be in for a rocky future, it also means that there are likely some great buying opportunities among companies with stronger-than-average balance sheets that are more likely to successfully withstand these pressures (such as Xinyuan Real Estate, which you can see our recent coverage of here and here).  Picking the right stocks will probably be the equivalent of shorting REE at $16.55. 

Disclosure: No position in REE or MCP.  Long XIN

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