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From boring
industrial metal to commodities superstar, copper’s wild bull market
has been full of excitement. Its huge 475% run from its 2003 low to
2008 high made investors fortunes. Its subsequent panic-driven 69%
plunge was catastrophic. And then copper’s resilient 183%
post-panic recovery to its recent April high has been breathtaking.
Futures traders, hedge-fund managers, and stock investors have endured
extreme highs and lows across this bull. And quite often they’re
left scratching their heads wondering what’s going to happen
next. But as any seasoned copper trader well knows, this base
metal’s only certainty is acute volatility. When it comes to
analysis, forecasting, or your best educated guess as to copper’s
future direction, be prepared to circumstantially adapt.
From a strategic perspective, copper’s secular bull is driven by
foundational economic fundamentals that will keep it alive for many more
years to come. But things get a little trickier when we look at
copper’s tactical price movements. Naturally technical,
sentimental, and shorter-term fundamental indicators serve as logical price
drivers. But as we’ve seen one should not rely on any single
indicator.
One such indicator that had been very reliable for us over the years was
London Metal Exchange (LME) stockpile levels. As the world’s
premier non-ferrous metals exchange, the LME must hold physical inventory for
when its contracts are redeemed. And thanks to the LME’s ability
to track the collective inventory of its global network of warehouses on a
real-time basis, we have a unique fundamental read on aboveground copper
supplies.
Now most of the world’s mined copper is shipped directly to the end
user after it is refined, leaving the volume that flows through these LME
warehouses insignificant as far as the global copper trade goes. But
these stockpile levels do play a vital role in the balance of the copper
market. If end users aren’t able to get enough of the metal from
their regular supply channels, these LME stockpiles serve to supplement this
excess demand.
LME stockpiles offer the largest source of accessible aboveground copper
supply. And with the metal flowing in and out of the warehouses on a
daily basis, these stockpile levels fluctuate accordingly. Well with
copper demand outpacing supply for an extended period of time, naturally these
stockpile levels are going to decrease on balance.
And when they fell to alarmingly-low levels where equivalent global
consumption was measured in mere days, these stockpile levels became a lot
more relevant as to where copper was being priced. As a result a
striking inverse relationship developed between stockpile levels and
prices. When stockpiles fell, prices would rise. And when
stockpiles mounted a build, prices would fall.
As you can see in
this chart, the inverse relationship between copper stockpiles and prices had
played out incredibly well from 2006 to 2008. LME stockpile levels
would fluctuate between about 100k to 200k tonnes in a tight horizontal trend
channel. At support a big risk premium was placed on copper, driving
its prices higher. While at resistance traders weren’t as nervous
about supply, which allowed copper prices to fall.
This relationship was apparent not only visually, but mathematically.
From Q2 2006 to the end of 2008, stockpiles and prices had an inverse
correlation of -0.852 with an r-square of 73%. This means 73% of the
daily behavior of copper’s price could be explained by the daily
movement of LME stockpile levels. This is a very strong inverse
correlation, and it was very actionable and reliable on the trading front.
But thanks to the first stock panic in 101 years, the integrity of this
relationship was nuked. Panic selling drove copper prices so low that
its inevitable bounce would happen regardless of interim fundamentals.
When copper finally hit its December 2008 panic low of $1.28, its lowest
price in over 4 years, it had actually fallen below the cost of production
for many of its miners. Well as expected, copper’s pop to the
upside recovered most of its losses. But the stockpile-to-price inverse
relationship would have trouble reconnecting.
As a result of the panic LME copper stockpiles mounted a huge build, soaring
to 550k tonnes. But this build didn’t come as too much of a
surprise considering nearly all economic activity temporarily ground to a
halt. Now in a normal environment a build of this magnitude would
obliterate prices. But with copper so deeply oversold it bucked the
trend and mounted a justifiable rise.
Finally in February 2009 LME stockpiles decisively rounded the corner and
shed some weight. And with copper prices rising on balance while
stockpiles were falling, the inverse correlation was back on. But this
return to normalcy was short-lived.
By July 2009 stockpiles changed directions again, mounting another
build. If this fundamental relationship held true, copper should have
at least consolidated, if not corrected. And prices were high enough to
afford a pullback. Copper had already soared 78% off its bottom and was
settling in nicely near $2.50. But prices kept on rising.
One year following the panic-build high, LME copper stockpiles had clawed
back up to the 550k-tonne level. And with prices also rising on balance
during this build, it became apparent we were in the midst of a huge
fundamental disconnect.
By all appearances traders were completely disregarding this once-reliable
fundamental read. And the math confirms the visual. From the very
day of copper’s panic low to current, stockpiles and prices are
sporting a correlation of 0.200 with a trivial r-square of 4%. What
this r-square value tells us is there is currently no correlation at all
between stockpiles and prices.
So what on earth is happening with copper? Why has this
stockpile-to-price inverse relationship seemingly disappeared? Are
today’s copper prices justified based on such high LME stockpile
levels? Well the easiest of these questions to answer is the
first. The horse that continues to pull copper’s carriage is the
S&P 500 index (SPX).
This visually-striking
chart provides the inarguable answer to what’s driving copper’s
price action. And the uncanny similarity between the SPX and copper was
born out of the Great Stock Panic of 2008. It is the actions of the SPX
that led to the panic selling of virtually all assets and markets around the
world. And copper, along with most of these other assets, has been
looking to the SPX to guide its post-panic recovery.
Most commodities and commodities stocks found their bottoms several months
before the SPX hit its own in March 2009. But when the SPX took off
from this bottom, its ensuing upleg gave confidence to copper and the rest of
the group to mount recoveries of their own. And as you can see copper
has emulated the SPX’s every move. Like the SPX it enjoyed its
own 10-month uptrend, and has also been dragged down with the SPX’s two
recent pullbacks.
Over the course of this tight uptrend that spanned most of 2009, copper more
than doubled in price. But as this upleg matured virtually every
indicator screamed for a copper correction. Copper was way overbought
technically, greed was waxing extreme, and LME stockpiles were mounting a
huge build. But copper would wait for the SPX to show its hand first
before it made a decisive move to the downside.
For nearly a year the SPX had not undergone a meaningful pullback. In
the early months of summer 2009 it did retreat 7.1%, but this loss was
quickly erased as the melt-up forged ahead. By January 2010 the SPX,
and copper, were way overdue for pullbacks. At the time my business
partner Adam Hamilton wrote pivotal essays discussing the SPX’s
staggering levitation act and calling for a copper correction. And
indeed this correction unfolded.
Also as Adam had predicted, this correction came on the heels of an SPX
pullback. Over 14 trading days into early February, the SPX had shed
8.1%. And over this exact same span copper shed 15.0%. But this
pullback was also short-lived. The SPX bounced off its year low and
charged higher with amazing resiliency, and to no surprise copper followed
suit. By April both the SPX and copper achieved new cyclical-bull
highs.
Well with renewed euro fears these highs didn’t last for long, and the
SPX entered into another retreat that has again taken copper with it.
And this ongoing correction is panning out to be the biggest yet. As of
May 26 the SPX was down 12.3%, with copper off 16.0% from its April
high. And there is no sign of copper stepping away from the domineering
effect of the world’s premier stock index.
It is apparent that with the ongoing uncertainty in the global economy copper
traders aren’t yet willing to price this metal on its own merits.
As shown in the chart above copper is mirroring the SPX’s every
move. And with copper and the SPX sporting an r-square of 95% from the
SPX’s March 2009 low to current, the math confirms this super-tight
correlation.
So for now traders must consider the fortunes of the SPX when gaming
copper. But when copper eventually diverges from the SPX’s grip,
which it will, where should it be priced? If we go back to the historic
stockpile-to-price inverse relationship, at current levels of 480k tonnes LME
stockpiles tell us prices should go down. But stockpile levels
aren’t the only thing we need to consider when pricing copper.
First, this LME data was never meant to serve as a primary indicator.
Yes, this stockpile-to-price relationship has been reliable in the
past. But technicals and sentiment among other indicators must always
be considered. Also, the fundamental read from this LME data might not
tell the same aboveground-inventory story now as it did a few years ago.
It is important to remember that LME stockpiles fell to such low levels as a
result of copper’s huge economic imbalance. According to the
International Copper Study Group (ICSG), from 2003 to 2007 copper’s
refined balance was negative 1500k tonnes. With less copper supplied
than was being consumed, the aboveground stockpiles were pilfered to historic
lows.
This stockpile draw not only went directly into products, but the end users
were building up their own inventories in order to secure copper for future
use. At the time there was no way of knowing how long this supply
deficit would last, so it was prudent to stock up on the metal.
Well as a result of the stock panic and ongoing global recession, from 2008
to current the ICSG calculates a supply surplus of about 480k tonnes.
Provocatively this happens to be the same amount currently stored in the
LME’s warehouses. Now this 2+ year surplus still represents a
tight balance, and in no way does it challenge the secular nature of
copper’s bull. But it does allow some wiggle room from an
inventory perspective.
With end users currently uncertain of their own sustainability, and now
comfortable that copper will be available in the warehouses of the major
metals exchanges if needed, they can afford to draw down the very same
inventories that they stocked up years earlier, their own.
You see, considering the current state of the economy higher LME stockpile
levels don’t necessarily mean overall aboveground copper supplies are
that much bigger than they were a few years ago. It might simply be the
case where consumers are drawing down their own private inventories, choosing
not to replenish in order to preserve capital. This will naturally lead
to an LME build as long as mine production stays consistent.
The scarcity, or perception of scarcity, of an asset is what causes consumers
to stock up. But when that sense of scarcity is eased, consumers are
more than willing to allow someone else to pay the carrying costs.
Unfortunately there is no way of knowing the collective inventory levels of
businesses and governments. But I suspect this higher LME stockpile
level is not as bearish as many think. If “private”
inventories are appropriately managed based on market conditions,
they’re probably a lot lower on balance than they were a few years ago.
Ultimately I believe it will take a bit of time to restore the
stockpile-to-price inverse relationship. But because of copper’s
newfound tight correlation with the SPX, it wouldn’t be the best
indicator now anyway. For this reason we can continue to look to the
SPX for copper and copper-stock trading cues.
And considering the SPX’s current oversold conditions, the door has
been opened to exceptional buying opportunities. At Zeal we’re
taking advantage of these bargains by buying elite copper and materials
stocks. In our weekly Zeal Speculator newsletter we’ve been
layering in to these stocks and options for a couple weeks now. And in
the upcoming June issue of our acclaimed monthly Zeal Intelligence
newsletter, we’ll be recommending several fresh new buys to our
subscribers. Subscribe today to view these trades and also gain unique
insights into today’s wild and crazy markets!
The bottom line is copper’s price action is still heavily influenced by
the fortunes of the SPX. While this market-darling base metal still has
rock-solid long-term fundamentals, the ongoing global economic uncertainty is
clouding the vision of copper’s market makers. Even the
once-reliable LME stockpile-to-price inverse relationship has factored little
into copper’s price action.
I suspect stockpile reads will eventually revert to normality once the
economy improves and the global growth story returns. And it is a
certainty that copper will eventually escape from the shadow of the
SPX. But in the meantime we can use the SPX as a guide for trading this
metal and its mining stocks. And with the SPX, and thus copper,
enduring sharp corrections lately, investors now have excellent entry points.
Adam Hamilton,
CPA
Zealllc.com
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Questions for
Adam? I would be more than happy to address them through my
private consulting business. Please visit www.zealllc.com/adam.htm for
more information.
Thoughts,
comments, or flames? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that I
am not able to respond to comments personally. I will read all messages
though and really appreciate your feedback!
Copyright 2000 -
2006 Zeal Research (www.ZealLLC.com)
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