Market and product
Copper is the red-hot commodity of 2011
Corrections are perfectly normal, necessary, and unavoidable within even the strongest bull markets. All prices flow and ebb, advancing two steps forward before retreating one step back. These ebbings are critical because they rebalance sentiment, bleeding away excess greed and complacency before it grows to upleg-ending or even bull-ending extremes. Corrections keep bull markets healthy.
It always amazes me how much traders resist the very idea of corrections when markets near major highs. As investors and speculators, our mission is to buy low and sell high. The best opportunities to buy low within any ongoing bull market only occur after a major correction has run its course. Only then is sentiment poor enough to yield seriously beaten-down prices in the stock markets and commodities.
This innate resistance traders harbor against corrections just before one ignites is often buttressed by fundamental arguments. But while core supply-and-demand fundamentals do indeed drive the primary secular-bull trends, they are completely irrelevant for corrections. Corrections are sparked by extremely unbalanced sentiment and overbought technicals. Fundamentals have nothing to do with them.
In copper’s case, today you will often hear that copper is heading higher because of fundamental factors. China is buying, the emerging world is industrializing, existing mines are depleting, miners are striking, new mines are years away from production, et cetera. But realize these indeed-bullish supply-demand trends have been in force more or less continuously since late 2001 when this secular copper bull was stealthily born.
Despite the inherent bullishness of global demand growth outpacing global supply growth on balance, copper still had to weather many major corrections over this past decade. So don’t fall into the rookie trap of rationalizing away extreme sentiment and overbought technicals with fundamental arguments. All bulls correct from time to time no matter how awesome their underlying fundamentals happen to be.
Unfortunately copper doesn’t share the stock markets’ excellent array of sentiment indicators. But if you look around, it is readily apparent consensus opinion is pretty darned bullish on this base metal. Articles in the financial press advance endless fundamental arguments for why copper is heading higher. And professional money managers, traders, and analysts interviewed on financial television expect the same.
But even though copper doesn’t have some neat indicator like its own VIX, its technicals are clearly overbought today. Its price has risen too far too fast to be sustainable. How can we know? By comparing copper’s recent highs to this metal’s technical conditions just before its previous major corrections. We’ll start out by examining the blue copper line compared to its black 200-day moving-average line.
In order to define “too far too fast” for copper specifically, we need some kind of baseline.And its 200dma is a perfect one. It gradually rallies to reflect the higher prevailing copper levels as this secular bull marches on, but still moves slowly enough to distill out all the day-to-day volatility. Expressing any price as a multiple of its 200dma (dividing the price by its 200dma) is the basis of my Relativity trading system.
In copper’s case, earlier this week this metal was trading at 1.287x (times) its 200dma. Compare this to the Relative Copper readings before each of its previous several corrections. In November 2010 before a sharp 8.7% retreat, this metric stretched to 1.217x. In April 2010 before copper plunged 23.4%, it climbed to 1.218x its 200dma. And in January 2010 before this metal fell 18.7%, rCopper peaked at 1.334x.
So we have plenty of precedent over this past year alone showing that copper is very overextended and overbought once it stretches 20%+ beyond its trailing 200dma. Copper running 1.2x+ is the point where traders need to start being wary of an imminent correction. Copper has a tough time sustaining an advance that sees it rally far enough and fast enough to exceed this benchmark. And this week we were well beyond that warning sign and pushing the super-extreme 1.3x level!
Now this alone warrants a very cautious near-term outlook on copper. The odds overwhelmingly favor a major correction. Again this has nothing to do with fundamentals, which are utterly irrelevant to short-term price action when sentiment and technicals reach extremes. Personally I wouldn’t go long copper or copper stocks based on this rCopper indicator alone when it’s at these levels. The near-term downside risk is far too high.
But add in a couple of other major factors driving copper prices, and the odds for an imminent correction approach certainty. They are the state of the general stock markets today and the trends in the London Metal Exchange’s global copper stockpiles. Each alone is a very ominous near-term portent for copper, and considered together along with copper’s overbought technicals present a nearly-ironclad correction case.
Believe it or not, the major driver of copper price action in its current cyclical bull since early 2009 is the state of the US stock markets! It sounds crazy at first, shouldn’t copper be reacting to its own supply and demand and not stock-market action? Of course. But the stock markets’ fortunes have a massive impact on traders’ sentiment worldwide. When the stock markets are up, they feel good and are more likely to buy commodities including copper. When they are down, traders dump everything including copper.
While this link is purely psychological, sentiment is what drives most short-term price action in anything. And there is some logic underlying this relationship. Advancing stock markets lead traders to expect an improving world economy, which means higher copper demand. So they buy this metal and the stocks of its producers. Retreating stock markets make traders assume the economic outlook is deteriorating, implying lower copper demand. So they react accordingly by selling the copper complex.
The best way to measure the US stock markets’ performance is through the broad S&P 500 stock index (SPX). It contains the 500 biggest and best American companies that collectively represent the vast majority of the total market capitalization of the US stock markets. In the chart above, I superimposed the past couple years’ copper action on top of the SPX in red. Their correlation is visually-astounding!
On a hard statistical level, this critical copper-SPX correlation is rock-solid mathematically as well. Since those brutal post-panic SPX lows in March 2009, copper has had a correlation r-square with the SPX of 93.4%. Over 93% of all the daily price action in copper over the last couple years is directly explainable by the SPX’s own! For whatever reason, copper traders are buying and selling copper in sync with the SPX.
And realize this relationship does indeed flow in this causal direction, from the SPX into copper. Every trader in the world watches the stock markets like a hawk. Their behavior and resulting psychological spillover affects everything else including copper. Meanwhile, general stock traders are definitely not eagerly watching copper prices to guide their every decision on buying and selling equities. The SPX is definitely influencing copper psychology, as suggesting copper drives the stock markets is absurd.
Note that all three of copper’s latest corrections in this bull, and 5 of 6 in total, corresponded exactly with pullbacks (less than 10%) or corrections (greater than 10%) in the SPX. Last November copper sold off 8.7% in just 4 trading days over a span where the SPX retreated 2.9%. Between early April and early June, copper plunged 23.4% over a span where the SPX corrected 10.7%. The worst copper correction of this entire cyclical bull was directly driven by the only correction in the SPX’s own cyclical bull!
And a year ago in January and February, copper dropped 18.7% in less than 4 weeks while the SPX fell 7.0% in its biggest pullback of this bull. Other than that initial post-panic recovery in 2009, which was an anomalous situation, every copper correction has perfectly corresponded with a parallel pullback or correction in the general stock markets. A retreating SPX scares traders into reducing all their risky trades, including copper exposure.
This is super-relevant today because the stock markets, for their own internal reasons that have nothing to do with copper, are also due for an imminent correction. I wrote an essay several weeks ago that explains exactly what is going on in sentiment and technicals in the SPX and why a correction looms. When (not if) the SPX inevitably rolls over, copper is going to get sucked into the maelstrom of selling like usual.
Copper just can’t resist the overpowering bearish sentiment that floods out of the stock markets when they are correcting. Almost nothing can, other than the US dollar and Treasuries which act as temporary safe-haven destinations for capital in times of mushrooming anxiety and fears. And today’s coming SPX correction is likely to be major, so all investors and speculators need to take its risks very seriously.
If you compare copper’s declines in its half-dozen corrections in this cyclical bull to the SPX’s parallel ones, both shown above on the chart, it is crystal-clear that copper tends to amplify stock-market downside. It is much more speculative than the stock markets, usually at least doubling SPX selloffs. So a garden-variety 15% SPX correction, no big deal at all, would probably lead to a massive copper correction approaching a third. Copper equities would get utterly slaughtered.
Several other factors argue for a serious copper correction beyond its extreme technical overboughtness and SPX-correction risk. After just hitting new all-time highs, copper is ripe for a selloff. Corrections off of records tend to be more severe, as such highs attract in new traders who buy near the top. These weak hands are easily spooked into selling fast.
In addition, copper hasn’t seen a material correction (over 10%) since last spring. It has rallied in a tight uptrend mirroring the SPX ever since, leading to very unbalanced sentiment. The longer any bull advances without a rebalancing selloff, the greater the odds one is coming soon.
And there is one final factor to consider that will really weigh on copper once selling starts. And it is fundamental! While fundamentals don’t matter in corrections sparked by sentiment and technicals, any temporarily-negative fundamentals can still add to this selling pressure. They exacerbate the bearishness and worries sparked by selling-off stock markets. Today the LME’s copper stockpiles are climbing again!
The London Metal Exchange runs a global network of warehouses that act as a buffer between copper miners and copper consumers. While most copper mined is shipped directly from producers to consumers, occasionally a miner will have excess production or a consumer will need more copper than usual. So these physical players can directly sell to or buy from these LME warehouses. The LME publishes its aggregate global copper-stockpile data daily. And it greatly impacts copper-price trends.
