Copper Correction

While copper is indeed entrenched in a secular bull driven by a long-term structural deficit, no price surges higher in a straight line forever.  This metal has rallied extremely far at a blisteringly-fast pace, with few meaningful pullbacks along the way.  So for a variety of reasons I’ll explore in this essay, copper is due for a serious and probably sharp correction.  Such an event will create great opportunities for traders.

When gaming corrections, sentiment and technicals always come into play.  Major retreats are the highest-probability outcome by far after popular greed waxes extreme and a price grows way overextended on its charts.  But copper’s situation here is unique, and far direr, because its fundamentals also strongly support this imminent-correction thesis.  All the cards are stacked against copper today.

The primary reason copper has enjoyed such an epic rally is because its price was driven so unbelievably low during the stock panic.  These gains only make sense when considered through the lens of that panic’s impact on copper.  In August 2008 before the stock panic hit, copper averaged $3.46 per pound.  This week, it was finally back to $3.44.  All 2009 did was counteract the crazy losses the panic spawned.

Despite this, copper is now way overextended technically and fundamentally.  And the driving force behind its hyper-optimistic sentiment today, the levitating S&P 500 stock index (SPX), is growing tired and brittle.  Given copper’s incredibly-strong correlation with the SPX since the stock markets’ March bottom, any material stock-market weakness will almost certainly spark a massive wave of copper selling.

Copper has become the SPX’s Siamese twin!  Since stocks’ despair lows in March, the technical chart patterns of copper and the SPX are almost interchangeable.  If I had mislabeled the blue copper line and red SPX line above, not many traders would catch the error with a casual glance.  For the most part, copper has been rallying when the SPX is strong and retreating when the SPX is weak.

This relationship extends well beyond the visual to the statistical.  Since the SPX bottomed on March 9th, the daily copper close has had a correlation r-square of 94.1% with the SPX.  This means 94% of copper’s daily price action is statistically explainable by the SPX’s own!  This is all the more remarkable considering I’m using copper’s global benchmark prices from the London Metal Exchange here.

Why would worldwide copper prices follow American stock markets with such precision?  One reason only.  The mighty advance in US equities has set the tone for universal sentiment.  Traders nearly everywhere, trading nearly everything, are seeing the continuing SPX rally and assuming it means underlying economic conditions are improving rapidly.  So they are bidding up nearly everything else with it.

Provocatively copper carved its own panic low near $1.28 in late December 2008.  But as you can see in this chart, it struggled near this low for months until the SPX finally started rallying in March.  With stocks’ despair finally morphing into hope, copper traders finally felt comfortable bidding up copper prices again.  This turning point had some fundamental underpinnings too, as copper stockpiles on the LME topped in late February 2009 just 8 trading days before the SPX bottomed.

Since the recovering stock markets first recast global economic expectations in a hopeful light again, copper has never looked back.  It has powered higher in a very-tight uptrend that mirrored the SPX’s own almost perfectly.  While such a steep uptrend was certainly justified in the first half of 2009 emerging out of those deeply-oversold lows, its continuing in the second half unchecked raises all kinds of concerns.

Between March and September, copper’s surge higher was very fast but properly punctuated by periodic pullbacks to rebalance sentiment.  In late April, copper plunged 12.2% in 8 trading days before resuming its nascent uptrend.  In June and July during the SPX’s own last meaningful pullback, copper slid 8.5%.  And finally in September, a third pullback dragged it down 9.8%.

Such two-steps-forward-one-step-back behavior is normal and expected in even the strongest bull-market advances.  The periodic pullbacks are a critical mechanism that keeps popular greed in check.  If greed gets out of hand too soon, it will burn itself out and prematurely kill the upleg.  All traders interested in buying soon will be sucked in, leaving no new near-term buyers.  At that point the upleg fails.

But since October, we’ve seen no meaningful copper pullbacks at all.  Copper’s first pullback happened about 1.5 months into this surge, its second another 1.5 months after the first one ended, and the third almost 2 months after the second ended.  But since early October, we’ve seen a very long 3+ month span where copper has relentlessly powered higher.  This is a long time for greed to flourish unrestrained.

Such unbalanced behavior has led to extremely overbought conditions.  In late October copper stretched 1.374x above its baseline 200-day moving average.  By early December and again this week it was back up to 1.331x.  This is extraordinarily overextended technically, a very dangerous place for copper prices to be.  These levels were rarely rivaled (or sustained) in copper’s strong bull years prior to the stock panic.

Between Q2 2004 and Q3’05, copper advanced relentlessly yet rarely exceeded 1.17x its 200dma.  After a short-lived parabolic spike higher in Q1 and Q2 2006, copper again stayed under this 1.17x metric at the tops of its strongest uplegs (and there were quite a few) between Q4’06 to Q3’08.  If you look at a Relative Copper chart (updated weekly on our website for our subscribers), it is very rare for copper to exceed 1.20x its 200dma.  Today’s sustained 1.33x+ levels are just absurdly overbought.

The driver of these extremes, as this chart reveals, has been the US stock markets’ seemingly unstoppable advance.  Copper tends to rally on days the SPX rises, but at a faster pace.  And it tends to sell off on days the SPX retreats.  But since the stock markets haven’t seen anything close to a meaningful pullback since June and July, the positive sentiment they are casting into the copper realm has been uninterrupted.

Given the stock markets’ state, this is very troubling.  Like copper, the SPX has long been very overbought as I’ve been chronicling in our subscription newsletters.  Complacency in the stock markets is extraordinarily high, almost everyone is bullish and nearly no one expects an imminent or sharp retreat.  Such conditions, technically overextended without a fear in the world, are the best breeding grounds for violent corrections.  The SPX has been overdue for a pullback for several months now.

And just as copper has eagerly followed the SPX higher like a lost puppy, it is sure to be hit hard when this SPX levitation act suddenly gives way.  Copper has rallied because rising stock markets have convinced copper traders that everything is well and the global economy is likely to grow faster than expected.  But falling stock markets breed economic fears much more efficiently than rising ones create economic hopes.  When the SPX’s enchantment on the economic outlook is dispelled, copper will fall fast.

While this metal’s greed-laden sentiment and incredibly-overbought technicals are more than enough to nearly guarantee an imminent sharp correction, the fundamental state of copper seals the deal.  The base metals traded on the London Metal Exchange enjoy a unique real-time window into their fundamental state that few other commodities share.  Every trading day, the LME publishes total copper stockpile levels across its global network of storage warehouses.

While most copper moves directly from the miners to the industries that consume it, the LME warehouses act as a buffer on the margins.  If miners produce more copper than they are under contract to provide, they can deliver it to LME warehouses.  If consumers need more copper than they have contracted to buy from miners, they can take delivery from LME warehouses.  Thus the trends in these LME stockpiles offer outstanding insights into copper supply and demand.

Normally copper-futures traders drive copper prices in opposition to whatever trend happens to be unfolding in LME stockpiles, which makes perfect sense.  When LME stockpiles are rising, it implies that copper supply growth is at least temporarily exceeding demand growth.  Traders generally sell copper in response to these near-term-bearish surpluses.  And when LME stockpiles are falling, demand growth is presumably exceeding supply growth.  Traders buy copper when these bullish deficits arise.

Amazingly, the long shadow of the SPX’s universal influence on sentiment has temporarily torpedoed this strong historical relationship between LME copper stockpiles and this metal’s prices.  Copper traders are so enthralled by the SPX’s seemingly impregnable advance that they have been willing to totally ignore utterly massive builds in copper stockpiles!  This is unprecedented.

Prior to late 2008’s stock panic, copper prices lazily meandered higher in opposition to LME stockpile levels.  When LME stockpiles were drawn down to the bottom of their pre-panic range, around 100k metric tons, copper prices rallied to the high end of their own range.  Conversely when LME stockpiles were built up near the top of their range, 200k tonnes, copper slumped.  This is a perfectly logical fundamental response.

LME stockpile levels normally influence copper sentiment in a variety of ways.  They act as a critical buffer in the case of any meaningful supply disruption, like some big copper mine going offline due to a labor strike.  The lower the LME stockpiles are, the smaller the buffer in the global copper trade to absorb any unforeseen shocks.  So lower stockpiles drive copper higher as it reflects a larger uncertainty premium.  Higher stockpiles give the markets breathing room in case of disruption, shrinking the premium.

In Q3’08 just prior to the stock panic, LME stockpiles were just under 210k tonnes at the top of their range.  This led to copper being down near its own trading range’s support, of course.  But when the panic hit, both copper traders and consumers were terrified.  Yet the miners kept on mining to pay the bills.  The traders sold copper futures aggressively, desperately dumping everything to get their capital out of harm’s way and raise cash.  So the copper price plummeted with everything else.

Meanwhile the copper consumers were reacting on two fronts.  Stock-panic sentiment was kindling fears of a new Great Depression, and industrial copper users didn’t want to overproduce their goods if we were facing such a bleak new economic reality.  So they scaled back purchases as much as their contracts allowed.  And for the copper they did need, prices were plummeting so fast that it made no sense to lock them in too soon.  With mined copper supply pretty stable while demand flagged, LME stockpiles soared.

By late February 2009 they peaked at just over 548k tonnes, a tremendously high level by previous years’ standards in their 100k-to-200k trading range.  But once it finally became clear that the despair was overdone and the neo-depression fears were silly, copper demand picked up relative to supply and LME stockpiles started dropping rapidly.  By mid-July they had plummeted 53.2% to just under 257k tonnes.

Over this span, copper prices soared 49.6%.  This February-to-July copper rally was totally fundamentally-justified.  With LME stockpiles quickly shrinking, apparently reapproaching their pre-panic trading range, copper prices needed to rise to reflect this persistent structural deficit.  Copper traders dutifully bid it higher as the LME buffer to absorb any copper supply shocks shrunk rapidly.

This worked until mid-July, when a disconnect emerged.  It was no big deal at first, but it has since grown into one of the weirdest copper anomalies I’ve ever seen.  A couple days before the LME stockpiles bottomed, the SPX’s last meaningful pullback ended.  Economic sentiment swung from pretty negative during that 7.1% SPX retreat to pretty positive once the SPX started surging higher again in the second half of July.  The spillover effect of these positive perceptions infected copper traders as well.

So they started buying futures again, but ignored the troubling fundamental undercurrent of rising LME stockpiles.  Early on, they could ignore the build and rationalize that stockpiles would soon turn south again.  But it never happened.  Like an ocean-going tanker slipping off course by a few degrees, at first this disconnect was trivial.  But as the weeks passed, it gradually grew into a major fundamental disconnect.

Between mid-July and this week, LME copper stockpiles soared by 97.5%!  Meanwhile, copper prices also rose by 51.4% over this very span, driven by the warm-and-fuzzy economic expectations the levitating SPX is casting.  One year ago, if you had told copper traders that they would drive copper 50% higher over a period of time where the LME stockpiles doubled, they would have laughed you out of the room.  Such a thing was inconceivably absurd to even consider.

Yet here we are.  Exceeding 507k tonnes this week, copper stockpiles are once again rapidly approaching their panic highs near 548k tonnes!  Yet in the couple months surrounding those highs, the copper price averaged $1.58.  Today it is over twice as high.  And back in the pre-panic days when copper last traded around today’s $3.40ish levels, LME stockpiles were only about 40% of today’s lofty levels.  This is just a stunning fundamental disconnect that cannot persist.

At some point here, probably soon, copper traders are going to snap out of their SPX-spawned enchantment and start thinking about stockpile fundamentals again.  That day will probably come when the SPX inevitably corrects, which will rapidly turn the economic perceptions pessimistic again.  The copper traders’ shock when they sit back and realize how foundationless the rally since July was will be serious.  I suspect there will be a rush for the exits and copper will plunge rapidly.

Just as the greedy sentiment in copper alone, or its terribly overextended technicals alone, argue for an imminent correction, so does its crazy fundamental disconnect over the past 6 months.  But when you add these sentimental, technical, and fundamental pictures together, it is nearly impossible to imagine copper not correcting sharply.  So we are probably on the verge of a perfect-storm copper correction, and the trigger that ignites it will likely be the arrival of the overdue SPX correction.

It’s funny, as many traders fear corrections.  The falling prices exert heavy psychological pressure on them, making them feel unsettled and frightened.  But as investors and speculators our mission is to buy low and sell high, and corrections create the opportunities to do both.  The peaks before sharp corrections emerge are the best opportunities to sell high within an ongoing bull while the subsequent troughs after corrections mature are the greatest opportunities to buy low.

At Zeal, we are capitalizing on both.  We just added a new options trade in Zeal Speculator this week that will surge if copper corrects sharply.  And late in December we finished a 3-month deep-research project looking into the universe of publicly-traded junior base-metals stocks.  We wrote and published a fascinating new 24-page report profiling our dozen favorite base-metals juniors.  These elite companies have outstanding projects and great fundamental potential to multiply in price many times over.

And a copper correction, which will drag down the rest of the base metals in a heartbeat, is the perfect event to create an outstanding base-metals-stock buying opportunity.  When these metals fall, probably in concert with the general stock markets, base-metals stocks will be crushed.  Those prudent investors and speculators anticipating this event will be ready to buy aggressively near the lows.  Now is the time to start researching to figure out which companies you want to purchase at bargain prices.  Buy our popular new junior base-metals stocks report today!

The bottom line is copper is drenched in greed, extremely overbought technically, and bucking its underlying bearish fundamentals.  Each one of these developments alone is certainly enough to spark a major correction, but all of them happening simultaneously virtually guarantees one.  Copper traders have been distracted by the stock markets’ levitation act, but once it fails the reckoning will come quickly.

When the SPX cracks, its stranglehold on traders’ imaginations will vanish.  Newly-awakened traders in all kinds of markets, including copper, will return to focusing on their own individual technicals and fundamentals.  The resulting sharp correction in copper to reflect its massive stockpile builds is going to create the best buying opportunity in base-metals stocks since their panic lows.  Be ready.

Adam Hamilton, CPA

January 8, 2010

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