Copper Prices - Too Overbought
(September 18, 2005)
Dear Subscribers and Readers,
We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of Friday at the close, the Dow Industrials stood at 10,641.94 - putting us at a slight loss of 25.94 points. We continue to maintain that the current rally is not sustainable - with two more weeks to go at the most. Our basic thesis remains the same from last week: Our position of staying 25% short is consistent with the loss of rallying power within the major brand names (as well as in the homebuilding and financial stocks), the underperformance of the Dow Jones Transportation Average, the drain of global liquidity as well as the fact that this cyclical bull market is now in its late maturity phase. One can now also add a declining oil price and a buildup of copper inventories (despite the ravages caused by Hurricane Katrina - which signals weaker economic growth going forward) to the list. We will continue to remain 25% short in our DJIA Timing System until further notice - but don't be surprised if we move to a 50% short position (which is our maximum allowable short position) in our DJIA Timing System within the next two weeks.
An update of our latest Market Poll on the U.S. Housing Bubble: So far, we have had a pretty good turnout in this poll - 267 votes in all. A whopping 69% thinks that the U.S. housing bubble is in the midst of topping out, while 15% does not think this is the case. The rest is neutral. Again, please vote if you haven't already done so and please also let us know what your thoughts are on the U.S. Housing Bubble (or lack thereof if you don't agree) by replying to our post in our discussion forum. I just hope that this survey does not turn out to be a contrarian indicator (no offense, this author can sometimes be as clueless as anyone out there).
Last week, we discussed the field and concept of financial engineering and how it fits in with the great issues of the 21st century, such as aging demographics, offshoring and outsourcing, and a fast-changing world in the context of globalization, etc. I also stated that one of our primary concerns is to keep our readers informed - all the more important given that not only is the world changing very quickly since the 1990s, but the pace of change has also accelerated as well. As a corollary, we also seek to keep our readers suitably informed not because the popular media fails to do so, but because the popular media is usually late, or worse, misguided or has chosen to focus on trivial instead of the more important facts.
As always, we try to discuss the important trends going forward in a little bit more detail than what the popular media does. For example, in our July 24th commentary, "Nothing is Obvious," we discussed the popular notion of what the Chinese Renminbi revaluation meant at the time, such as the potential of a "dollar crash" (due to the fact that the Chinese Central Bank will purchase less U.S. Treasuries going forward) and a continued rise in the Chinese Renminbi in the order of 15% to 40% over the next few years. We disputed these "findings" of the popular media - stated that "nothing is obvious" and that arguments based on Central Bank buying is only one (small) part of the overall equation. We discussed that private demand for U.S. Dollars has actually risen in recent months, and that we would not be surprised if the U.S. dollar actually appreciates against the Chinese Renminbi at some point in the near future. Since that time, watching the action of the Chinese Renminbi against the U.S. has been akin to watching paint dry - with only a further (negligible) rise of 0.3% over the last couple of months. Again, this author would not be surprised if the Renminbi-to-U.S. Dollar ratio rises above the 8.11 revaluation level that was set by the Chinese government at some point down the road - especially if economic reforms in Japan or Germany do not come to pass (as I am writing this, the outcome of Germany's election is still very uncertain but it definitely looks like the economic reforms that Angela Merkel has pushed for will definitely not come to pass).
In the tradition of "Nothing is Obvious," I now want to discuss two other things that are not routinely discussed by the popular media - those two being cash levels at U.S. corporations and the implications of defined benefits pension plans reform on the U.S. equity markets. First, cash levels of U.S public corporations. Many numbers have been routinely thrown around, but according to the Bank of America, the aggregate cash level of companies in the S&P 1500 is approximately $2.5 trillion - a very impressive level given that the total market capitalization of the S&P 1500 is "only" $13 trillion. Conclusion of the popular media: This huge amount of cash will act as a "cushion" to prevent any future stock market declines through stock buybacks, cash acquisitions, etc. While this is a plausible argument on the surface, this author will argue otherwise.
First of all, according to the same BoA study, the total cash level of the financial sector is approximately $1.6 trillion, or a whopping 64% of all cash levels in the S&P 1500. That only leaves $887 billion divided among the other nine sectors of the S&P 1500, which includes energy, materials, industrials, IT, consumer discretionary, consumer staples, health care, telecom services, and utilities. Second of all, there are two significant off-balance items that we need to be concerned about, namely the value of options held by insiders, as well as defined benefits pension plan deficits (as measured on a FAS 87 basis). The option value and the pension deficit of the S&P 1500 (excluding financials) is $366 billion and $175 billion, respectively, Factoring in both the value of options held by insiders and pension deficits (which are projected to only grow in the foreseeable future), we obtain a cash balance of only $346 billion for the companies in the S&P 1500 (again, excluding financials) - a number that is significantly less than the $2.5 trillion balance as publicized by the popular media. Furthermore, pension reforms for defined benefits plan (which holds approximately $1.6 trillion worth of U.S. equities) are also expected to result in the decrease of equity allocation of U.S. defined benefits plans going forward. This author is estimating an immediate 10% reallocation out of equities, while the Bank Credit Analyst is predicting a huge shift ($600 billion) from equities (and other risky assets) and into bonds over the next nine years. The intentions of both Congress and the PBGC is two-pronged: To bring the severe deficit of the PBGC in line and to make sure that this deficit scenario does not occur again once this deficit has been brought in line. This is not bullish for the stock market.
So much for cash levels and defined benefits plans (not that anyone under the age of 40 in this country will care - unless you were a pension actuary). Let's now go on to discuss a commodity which we haven't focused too much on in our commentaries, namely the supply/demand dynamics of the copper market and copper prices. For readers who have no background in the copper markets, I will not venture to summarize the historical supply/demand dynamics of the industry, since many websites out there can do this better than I do. These websites include Kitco, Basemetals.com, as well as the International Copper Study Group. One can find good summaries of the copper market by surfing to those websites. For readers who do not want to go to all that trouble, you can also find a very good summary and description of the copper market on the Aur Resources website.
Dear subscribers, before you go on to read this, you may want to note that I am by no means an expert on the copper market. Rather, I am an economist by trade - and prefer to look and analyze everything from a big picture perspective. That being said, I do try to read up on everything about the commodity before I write anything, such as reading up on the implications of the Asarco strike, as well as the fact that many companies that mine copper are shifting some of their focus away to producing molybdenum in light of a 1,500% appreciation in the metal over the last two and a half years.
Unless one has been in hibernation over the last two years, one would surely know that copper prices have been rising relentlessly over the last two and a half years - hitting a new all-time high of approximately $1.70 per pound in the wake of Hurricane Katrina in the beginning of this month. The industry has been operating in a deficit situation over the last two years, as production have been less-than-expected while copper demand from China had increased exponentially over the same period. That being said, recent developments suggest that copper prices have most probably topped out in the short-term. These include:
- A potential slowdown in real estate construction in China. Most recently, building vacancies in China have been increasing year-over-year, as well as the fact that many potential homeowners are now waiting for prices to cool down before buying a house. Despite an increase in vacancies and despite the slowdown in house price appreciation, commercial housing development is still up 23.3% year-over-year. At some point, however, construction will inevitably slow down, especially since the government is still making a conscious effect in cutting down on speculative building. This is important since the construction sector is the biggest consumer of copper, and also since China is the world's biggest importer of copper.
- The most recent underperformance of the homebuilding stocks suggests that the growth in housing starts will decline going forward. More importantly, the affect effects of Hurricane Katrina on copper demand (mostly in the rebuilding efforts in Louisiana and Mississippi) are not expected have an impact until many months from now. Moreover, readers should keep in mind that this is literally a rebuilding effort, in that scrap metal and other salvageable materials (including copper) can potentially be recycled, thus partially muting the positive impact on copper prices. Interestingly, the futures market is not expecting the rebuilding efforts to place any considerable strain on copper supplies, as the forward contracts in copper are signaling significantly lower prices over the next three to 24 months (which means there is only a significant supply constraint in the very short-term).
- New automobile sales is expected to slow down significantly going forward, after new vehicle sales came in at 20.9 million units for July this year - the highest number of unit sales since October 2001. August was significantly weak - coming in at an annualized number of 16.8 million. New vehicle sales is expected to remain weak, as the economy is expected to slow down in the coming year and as the company incentives from GM and Ford earlier this year most probably cannibalized a significant amount of sales that would not have occurred until later this year. Since new automobile sales have historically been a good leading indicator of copper prices, this development is definitely bearish.
Since the recent rise in copper prices has definitely been the result of short-term supply constraints, it is imperative that we take a look at the LME Copper Warehouse stocks level. While copper inventories are still hovering near historical lows, it is interesting to note that current inventory levels have risen by more than 200% since their all-time lows in late July. In fact, inventory levels are now at their highest levels since October 2004 - when the spot price of copper was trading in the range of "only" $1.28 to $1.48 per pound. Following is the one-year chart showing LME Copper Warehouse stocks from September 16, 2004 to September 2005, courtesy of www.kitco.com:
Of course, being an economist by heart, there is obviously no escape from looking at the current dynamics in the commodity from a macro standpoint. In looking at commodity prices in the past (such as the CRB Index and the CRB Energy Index), we have incorporated the use of our MarketThoughts Global Diffusion Index (MGDI). The latest chart of our MGDI can be found in last week's commentary - and is definitely calling for lower copper prices up ahead. The MGDI aside, there has also been a very reliable historical (inverse) correlation between the direction of the Fed Funds rate and copper prices - with the former leading the latter by approximately 20 months. Following is a chart showing the inverse relationship between the month-end Fed Funds rate (set forward by 20 months) vs. the month-end copper spot price from January 1984 to September 2005 (using last Friday's close as the September month-end price). Please note that the left axis for the Fed Funds rate has been inverted, as well as the fact that the Fed Funds rate has been projected to increase to 3.75% by the end of this month:
History has suggested that whenever the Federal Reserve starts hiking the Fed Funds rate, copper prices will decline - with a lag time of approximately 20 months. If this historical relationship holds true, then the time is ripe for copper prices to start correcting here - even if the Federal Reserve chooses to pause during this Tuesday's meeting (which is highly unlikely anyway given that the futures market is indicating an 87% chance of a 25-basis point hike).
Now, since I am also a technical analyst - along with the fact that I am also a student of sentiment indicators, we are now going to take a look at the bullish consensus for copper vs. the copper spot price. Following is the daily copper spot price vs. the Market Vane's Bullish Consensus from January 2003 to September 16, 2005:
As readers can see, investor sentiment in copper is now extremely bullish. Not only are both the 21-day and 55-day moving averages of the Market Vane's Bullish Consensus at extremely elevated levels (approximately 80%), but please note that these same moving averages of the Market Vane's Bullish Consensus hae been over the 70% level since January - with no substantial correction over the last eight months. Moreover, these same moving averages have consistently been over the 60% level since October 2003. Bottom line: Bullish sentiment in copper is now extremely overbought - and given the current fundamentals and sentiment, chances are that the price of copper will correct very shortly.
Let's now turn to the U.S. stock market. This current market has been one of the most confusing markets we have ever seen - especially when one takes into account the hugely divergent tape. Energy, semiconductor, and energy stocks continue to remain strong, while other stocks in the financial, retail, and homebuilding sector have been severely lagging. The action of the Dow Industrials and the Dow Transports definitely don't tell the whole story, but let's first take a look at the most recent market action with the following daily chart of the Dow Industrials vs. the Dow Transports:
While the Dow Transports did experience a slight bounce of 11 points last week, it is by no means a significant bounce - especially given the further decline of crude oil prices. The negative divergence by the Dow Industrials also cast a shadow over this bounce. For now, the Dow Transports remains very weak, with the last high made more than six months ago. Since the Dow Transports has been a leading indicator of the broad market since March 2003, this author believes that we should "heed" the weakness in the Dow Transports. Moreover, this author contends that any further rally here would most likely not bring the Dow Transports above its early March highs - and thus the market is most probably going to see more downside further down the road.
Even as the two major Dow indices held their own, the internals of the market continued to deteriorate, as we highlighted last week by looking at the recent action of the NYSE McClellan Oscillator and the Summation Index. The sentiment indicators continue to remain neutral as a while (if one takes into account the oversold Rydex Cash Flow Ratio reading at 0.89). but the NYSE ARMS Index is getting very overbought, as indicated by the following chart showing the 10-day and 21-day moving averages of the NYSE ARMS Index vs. the Dow Industrials:
As mentioned in the above chart, the 10-day moving average of the NYSE ARMS Index is now at 0.908 - a very overbought reading which we have not witnessed since June 22nd. A daily reading of below 1.05 on Monday will take the 10-day moving average below the critical 0.90 reading - a sure warning of stock market losses to come. Again, this author would give this market (just like copper) one more rally - and then that's it.
Okay, the author is now finishing this commentary up just as the European markets is about to open for trading on Monday. It now looks like the German DAX is now set up for a significant fall, given the weekend election has most probably ended in a stalemate - which is basically the worst of all possible worlds. The fact that the DAX has rallied over 17% this year would probably not help towards cushioning the potential fallout of this stalemate. Keep in mind that U.S. investors have increasingly gone overseas to invest during the last couple of years. Does anyone remember the "flight to quality" scenario that we have discussed on and off during the last six to nine months? Any potential flight to quality scenario is further compounded by the fact that the U.S. Dollar is oversold - along with the fact that U.S. equities have been relatively shunned by world investors over the last 12 months. The election stalemate may have just very well been the trigger for such a scenario. If that is indeed the case, then both the Euro and the equities of the Euro Zone are definitely a 'Sell" here.
Let's now quickly take a look at our most popular sentiment charts, as this commentary is getting very long already - starting with the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials:
While the bulls-bears% differential readings in the AAII survey is no longer oversold, this author is still looking for one more rally before the bears will get a good chance to wrestle control away from the bulls. However, given the continuing deterioration in market internals, I don't believe the bear scenario will be that far away. For now, we will remain 25% short in our DJIA Timing System - with a possibility of switching to a 50% short position in the next couple of weeks.
The Bulls-Bears% Differential in the Investors Intelligence Survey, meanwhile, again held relatively steady in the latest week - as the bulls-bears% differential increased from 24.0% to 26.6%. Moreover, the four-week moving average reading (26.6%) is actually somewhat oversold:
Given the still-low weekly and four-week moving average readings of 26.6%, this author is again calling for one more rally here - in order to bring this survey to a more overbought status before calling for a potential decline. This also applies to the Market Vane's Bullish Consensus, even though the most recent weekly readings are really not that oversold:
During the latest week, the Market Vane's Bullish Consensus remained steady with a reading of 65% - hovering between "overbought" and "extremely overbought." As I mentioned in the above chart, this author would like to see the weekly reading in this survey rise back up to the 67% to 70% range before calling for a significant top. We are definitely running out of steam, folks - but that does not preclude the market from making a final attempt to rally - a rally which will be narrow in breadth and which will most probably be an "exhaustion rally."
Conclusion: The two-and-a-year rally in copper prices is most probably coming to an end - although prices can stay elevated for years (above $1.10 per pound) as demand from China continues to increase. That being said, there are currently many bearish trends developing for copper, both in the short term (such as sentiment) and intermediate term (a potential slowdown in Chinese housing construction and a drop off in new domestic vehicle sales). The fact that LSE Warehouse Stocks are being replenished at such a feverish pace isn't such a bullish development either. After all, it was only two months ago when various analysts were calling for a "default" because of the potential "exhaustion" of LSE Warehouse Stocks. Such doomsday scenario usually does not materialize, and it is now time for the copper bulls to take a break.
I also want to take this opportunity to remind our readers that "nothing is obvious" and that every article about the stock market that you see in the popular media should be checked with great scrutiny - with the "corporations are flushed with cash and therefore the market can never go down" scenario being the prime example. Finally, as I have outlined in the last few weeks and in this commentary, this author is now getting more bearish by the day, especially in light of the stalemate of the German elections. The world desperately need countries like Germany and Japan to "right themselves" and this stalemate in the German elections is the worst of all possible worlds, especially given that Angela Merkel had virtually won the election a month before elections even begun. Such a stalemate is not good for globalization, and subsequently, not friendly to world economic growth going forward. Both the Euro and equities in the Euro Zone countries should now be avoided. For now, we will remain 25% short in our DJIA Timing System (although U.S. equities should do relatively well compared to Euro Zone equities) - and possibly looking to go 50% short within the next couple of weeks should the major market indices continue to rally during that time.
Henry K. To, CFA