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Copper in the Midst of Topping Out

(November 20, 2005)

Dear Subscribers and Readers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  For now, we are completely neutral and in cash.  Even though in the short-run, the market is very overbought and should be subjected to a correction anytime now, it is still in an intermediate uptrend for now - a trend that should last until at least the end of this year.  This author, however, does not recommend committing substantially on the long side, given that many of our longer-term indicators are now rolling over, such as our MarketThoughts "Excess M" indicator, as well as the fact that both the U.S. Federal Reserve and now the European Central Bank remain in a tightening basis at least until January of next year.

Talk about the dangers of "showing your hand" in poker and in the financial markets.  Starting with our November 6th commentary on bonds, we argued that retail investors were "showing their hands" in various markets such as the energy markets, and the stock market in general.  We also discussed the inherent danger when one "shows his hand" in the financial markets - said strategic mistakes which had resulted in the demise of Long-Term Capital Management in the Fall of 1998 as well as the near-demise of Enron Oil in October 1987.  Readers who are familiar with financial history should know this: When one is stuck with a large, illiquid, and levered position that is a bet against the current prevailing trend, chances are you're already 90% of the way towards bankruptcy.  The 1997 Zhuzhou short squeeze in zinc was one major example.  A more recent example is the demise of China Aviation Oil in late November of last year.

So Henry, how does this argument relate to the current trend in copper prices?  And how do the 1997 Zhuzhou Smelter and the 2004 China Aviation scandals come into play?

Let's now answer the first question.  In our September 18th commentary, entitled: "Copper Prices - Too Overbought" we first discussed why copper prices were very overbought and why they were close to topping out.  We discussed that real estate prices and transactions were declining in China, the U.S., the UK, and Australia.  With regards to the US, we discussed the dismal performance of the homebuilding stocks as a good indicator of potential declining demand, as well as lower demand because of declining automobile sales.  Since our September 18th commentary, none of these bearish factors on the demand side have changed.  If anything, the declines in copper demand have continued.  In the major real estate markets in China, real estate prices have declined further and transaction volumes have literally collapsed.  Moreover, the major homebuilders listed on the U.S. stock exchanges have been consistently missing their earnings targets - something that had been unheard of for the last three years until recently.  Finally, new vehicle sales for the first 13 days of November is still down 15% on a year-over-year basis, after declining by 33% in October - this despite recent declining gas prices since Hurricane Katrina hit a few months ago.

Indeed, even though copper warehouse stocks on the London Metals Exchange (LME) have again declined since our September 18th commentary, readers should note that warehouse stocks (following chart courtesy of Kitco) are still 160% higher than where they were back in late July/early August earlier this year:

1 Year LME Copper Warehouse Stocks Level (Nov 18, 2004 to Nov 18, 2005)

The problem with this analysis, however, is that a 63,800 ton inventory is really trivial in the grand scheme of things - given that China alone consumes 3.5 million tons of copper every year.  More importantly, however, is the recent speculation that a certain Chinese metals trader working for China's State Reserve Bureau has a near 200,000 ton short position in the metal - set for a delivery date of December 21st.  Readers who are interested can go to the "market commentary" section in our discussion forum and browse through my posts on copper for more details.

It is important to keep in mind that many reporters who are currently writing up the article are still speculating at this point.  The official news coming out of the Chinese government right now is still pretty sketchy.  For example, the spokespeople at the LME have gone on record and stated that they believe the markets will remain orderly; if any trader is short 200,000 tons of copper and do not have the ability to deliver that obligation by December 21st; then the markets will definitely not remain orderly.  Such a trade (piling 200,000 tons into one contract) also does not make logical sense, as any potential upside is limited while any potential downside will be huge.  In the very short-run, however, all that matters is perception and sentiment.  This author is now looking for a possible short trade in copper (although this definitely should not be interpreted as investment advice).  Assuming that the "worst-case scenario" occurs and the Chinese government is on the hook for the 200,000 short position, there is no question that the cash price and the December contract will go sky-high in the next four weeks.  In such a scenario, I would not be surprised if we see a $2.50 or $3.00 per pound cash price on the NYMEX if such an event did occur.  Keep in mind that the cash gold price ran up from $400 to $850 an ounce in a matter of seven weeks before it finally peaked in late January 1980.  We had a similar "blowoff" situation in the NASDAQ in 2000 although it took a longer time to run.  The great thing about the current copper situation is that we more or less know the timeframe (that is, the delivery date).  I remember shorting the NASDAQ starting in late January 2000 and for the next six weeks, I was literally sweating bullets.  If one was off ten days in shorting gold in January 1980, he or she would have literally gotten killed since the gold cash price ran up from $600 an ounce to $850 an ounce during that period.  Such a case should not happen with the current copper situation - given that the Chinese government has more or less "shown their hand" with regards to the delivery date.

That being said, no one would be foolish enough to short the December 2005 contract.  However, my guess is that any run up in the cash price and the December 2005 contract would "pull up" the March 2005 and the May 2005 contract as well - and those are the contracts that this author is looking at very closely right now.  After this run-up and after December 21st, the ensuing collapse should happen just as quickly, as I don't believe the fundamentals support the current price of copper (nor the prices of copper over the next 12 months as implied by the current futures contracts).  Numbers and statistics by official agencies are fine, but my "gut feel" feels otherwise. 

Moreover, bullish sentiment, as measured by the Market Vane's Consensus, is at extremely bullish levels - usually a good contrarian indicator.  In fact, the latest weekly reading of the Market Vane's Bullish Consensus for copper came in at 89% - the highest reading since early October 2005, and prior to that - May 1997.  Moreover, the 21-day moving average of the Market Vane's Bullish Consensus just touched a reading of 84.8% - the highest reading ever recorded for this indicator.  Following is a chart showing daily copper spot prices vs. the 21-day and the 55-day moving averages of the Market Vane's Bullish Consensus:

Daily Copper Spot Prices vs. Bullish Sentiment (January 2003 to Present) - Copper spot prices hit an all-time high in the wake of Hurricane Katrina, and this has continued over the last three months.  Interestingly, the bullish sentiment in copper has not had a significant correction (21 DMA below 70%) since January this year - suggesting that copper is hugely overbought.

Please note that since our September 18th commentary, bullish sentiment has continued to climb - with the 21-day moving average of the Market Vane's Bullish Consensus now at 84.8% and having never declined below the 70% level since ten months ago.  "Bullish" news like the possible squeeze of the Chinese government - combined with declining fundamentals and high bullish sentiment - usually coincides with a bull market finally topping out.  Recent and historic examples include the shut-in of 80% of Gulf oil production in September earlier this year, the $1 trillion market cap call for Cisco in March 2000, as well as the cornering of the silver markets by the Hunt brothers in late 1979/January 1980.  I don't believe that things are different this time.  My guess is that the topping out of copper prices within the next few weeks is inevitable.

Okay, Henry, so how does this relate to the Zhuzhou Smelter and the China Aviation scandals?  I believe that the current situation is very similar to what occurred with zinc in May to September 1997. And although a very similar situation occurred in China Aviation Oil in November last year, subscribers should keep in mind that there is one significant difference.  The difference was that the zinc episode occurred while the Asian Crisis was starting to unfold.  That is, zinc prices were skyrocketing even as the Asian countries and demand were collapsing.  We did not see that with oil at the end of last year, as real oil demand was still increasing, but chances are that copper is in a similar situation as zinc in 1997.  The continued tightening of the U.S. Fed and now the European Central Bank should also put a lid on copper prices, as well as gold and silver prices in the coming months.  I also believe that the current run-up in gold prices is a "blow off," and nothing more.  That is, it should not be interpreted as some kind of "break out."  Let's now take a look at what happened to zinc prices during that fateful period in 1997:

Daily Cash Prices of Zinc at the LME (US$ Per Ton) (August 1995 to March 1998) - 1) After three days of meetings in Beijing, the SRB decides to release 40,000 tons of zinc, and mobilized other smelters to deliver 40,000 tons to the LME in August and September.  Altogether, 218,000 tons of zinc was delivered to the LME warehouses in Singapore in 1997 - while 110,000 tons of the remaining obligation was rolled over to 1998.  The price of zinc subsequently collapses. 2) When the price starts to rise, Zhuzhou shorted another 280,000 tons.  With an annual production capacity of only 100,000 tons, it has lost the ability to deliver to the LME.  Meanwhile, officials of Zhuzhou denied that they had a short position in the zinc markets, as rumors circulated around the LME of a potential short squeeze in zinc. 3) Zhuzhou Smelter sold short 170,000 tons of zinc via a Hong Kong subsidary through 16 different agents in May 1997.  This was done at a price below $1,300 a ton with the delivery dates in throughout 1997.

Just like the recent short trade in copper, the short trade in zinc in May 1997 done by Zhuzhou Smelter was not a totally illogical trade.  In fact, from a fundamental standpoint, it made perfect sense - as any "insider" in China at that point most probably knew that many of the economies of the "Asian Tigers" were slowing down dramatically and that a general collapse of commodity prices was not too far away.  What they did not count on, however, was a short squeeze engineered by other metals traders.  As soon as they had placed their short trade in May 1997, many of the traders already knew that Zhuzhou had a big, illiquid, short position.  By July, rumors of a short squeeze were widely known around the financial world.  The fate of Zhuzhou was sealed when they chose to short another 280,000 tons - thus effectively wiping out their ability to deliver the metal.  Like I said, this current short trade in copper looks to be very similar in nature to the short trade in zinc back in 1997, as the demand for copper has recently dropped and as bullish sentiment in the metal is now at extremes.  Be careful, however, as the last days of the bull market can often be very violent.  For illustration purposes, note that the cash price of zinc rose approximately 24% in the last four weeks immediately prior to the ultimate top of US$1,760 per ton on July 28, 1997.

Before we go on and discuss the most recent action of the stock market, readers should note that I am still relatively bearish on both crude oil and natural gas prices.  In our commentary last Thursday morning, I stated: "What most analysts have not discussed over the last six months is the fact that industrial demand has been severely tanking - anywhere from 5% to 10% on a year-over-year basis.  That is, for some industrial users, the recent high natural gas costs represented the final nail in the coffin - and they are either moving their operations overseas or shutting down their operations altogether.  If this downtrend in industrial demand continues, then this author would not be surprised to see a 60 BCF (billion cubic feet) per month decline in industrial demand this winter.  Combined with the fact that natural gas production in the Gulf of Mexico should continue to recover, my guess is that the January 2006 natural gas contract - currently trading at over $13/MMBtu - is at best, fairly valued, even assuming a colder-than-expected winter."  Since that commentary, the January 2006 contract has declined from just over $13/MMBtu to $12/MMBtu.  Again, my guess is that both crude oil and natural gas prices will continue to decline in the coming weeks.

Let's now take a look at the most recent action in the stock market.  Amazingly, the Dow Transports continues its meteoric rise - again making an all-time high by closing at 4,140.69 last Friday afternoon.  Since the October 21st low, the Dow Transports has rallied 14.3%.  Should the Dow Transports continue its current rate of ascent, it would close at nearly 5,000 by the end of this year!  Of course, such a run is highly unlikely, and given that the general market is so overbought at this point (the daily equity P/C ratio closed at 0.46 while the ten-day moving average of the NYSE ARMS Index closed at 0.83 last Friday), this author thinks the most likely scenario would be for the market to correct in the very short-run.  Over the intermediate term, however, the current uptrend remains intact.  Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to November 18, 2005) - Fortunately, we do not have to readjust our scales again for the Dow Jones Transportation Average this week, even as it continued to make its ascent to another new all-time high.  For the week, the Dow Industrials rose 80 points while the Dow Transports raked in another respectable gain of 67 points.  Ever since its low four weeks ago, the Dow Transports has appreciated an astounding 14.3%.  At this rate, the Dow Transports will close near 5,000 by the end of this year!  At the same time, however, the Dow Industrials has only appreciated 5.4%, severely lagging the Dow Transports - although still a respectable gain, nonetheless.  My guess is that the Dow Industrials will eventually surpass its March 4th high of 10,940.55, but definitely not its all-time high.  For now, we will continue to stay neutral and not chase any rallies from current levels.

In last week's commentary, I stated: ". my guess is that the Dow Industrials will surpass its March 4, 2005 high of 10,940.55 over the next few weeks.  This is purely a conjecture, but such a "confirmation" should lure more investors to the bullish side - thus finally setting us up for a significant top . If what I have conjectured turns out to be true, then it would be one for the Dow Theory history books.  Not because anyone will be made famous by this "call," but because under Dow Theory terms, such a top would be a case of a "textbook top.""  It is to be said here that at the tail-end of all bull markets, the market usually stays irrational longer than anyone thinks.  Such was the case with gold and silver in January 1980, the Nikkei in 1990, as well as the NASDAQ Composite in early 2000.  This is what has been happening with copper, as well as the stock market.  If the cyclical bull market is to end soon, then we should have a "blow-off" of significant proportions - a blow-off which should definitely take the Dow Industrials above its March 4, 2005 highs - thus sucking in all the investors who are currently on the sidelines.  Only then would this cyclical bull market finally end.  Please note, however, that this author is not looking for an all-time high in the Dow Industrials, although stranger things have happened.

Let's now discuss our most popular sentiment indicators - starting with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials.  The latest weekly reading pretty much remained steady in the latest week - declining from a highly overbought reading of 36% to a still overbought reading of 32%.  Meanwhile the ten-week moving average jumped from 8.9% to 11.2%, suggesting a continuation of the intermediate uptrend:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey continued to stay at an elevated level in the latest week - declining slightly from 36% to 32%.  Over the short-run, this survey has gotten very overbought.  The ten-week moving average, meanwhile, rose from 8.9% to 11.2% - which most probably mean that this rally has further to rally, notwithstanding any short-term consolidation.  For now, we will remain neutral in our DJIA Timing System, unless the market experiences a sharp-enough correction which will allow us to jump in.

In last week's commentary, I stated: "While this indicator is very overbought on a short-term basis, the fact that the ten-week moving average is still only at 8.9% suggests more upside in the coming weeks, even though the market "should" correct or at the very least, consolidate over the next five to ten trading days."  With the ten-week moving average currently only at 11.2%, this statement still applies.  Unless the market experiences a sharp and quick correction, however, this author will sit on the sidelines, for now. 

The Bulls-Bears% Differential in the Investors Intelligence Survey, bounced up 4.3% in the latest week - with the latest weekly reading rising from 25.9% to 30.2%.  Meanwhile, the four-week moving average increased from 19.2% to 22.8% - suggesting a continuation of the current intermediate uptrend, even though on a very short-term basis, the market is still hugely overbought:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey jumped from 25.9% to 30.2% in the latest week - continuing the short-term uptrend from four weeks ago.  The four-week moving average, meanwhile, increased from a reading of 19.2% to 22.8%.  This survey is still implying more upside in the intermediate term, although this does not mean there won't be any corrections or consolidation in the short-run.

Both the readings in the AAII and Investors Intelligence Surveys are implying a continuation of the current intermediate uptrend, even though on a very short-term basis, the market is hugely overbought and should correct or at least consolidate over the next couple of weeks.  Again, for subscribers who choose not to go long, this author would not recommend going short either - unless you really know what you're doing.  The end-of-the-year action is known for its short squeezes.  Better to sit back and enjoy your upcoming Holiday time.

As for the Market Vane's Bullish Consensus, the most recent weekly reading increased slightly from 63% to 64%. The four-week moving average increased from 60.3% to 62.0%, and again, the four-week moving average of the Market Vane's Bullish Consensus is telling me that the intermediate uptrend is still very much intact:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus rose slightly from 63% to 64% in the latest week.  Meanwhile, the four-week moving average increased from 60.3% to 62.0% - which still represents a slightly oversold reading relative to the readings since January 2004.  The most likely scenario is for this survey to trend higher in the coming weeks.  Like I have been mentioning over the last 15 months, however, this author would still like to see a weekly reading at the 50% to 55% level (which we have not seen since November 2003) before he is willing to commit substantially on the long side.  For now, we will remain completely neutral in our DJIA Timing System.

At this point, this survey is still oversold enough to give us some further upside - with a possible new high (a high that surpasses the March 4th high) in the Dow Industrials as well as a new all-time high in the S&P 600 and Russell 2000 (the S&P 400 actually made a new all-time high last Friday).  Bears should definitely stay on the sidelines for now.  However, this stock market will most probably again be "a short" when this survey becomes overbought again.  For now, we will remain completely neutral in our DJIA Timing System.

Conclusion: Since our initial September 18th commentary on copper and copper prices, this author has kept track of the commodity on a daily basis - and our latest analysis leads to a highly probable top in the commodity sometime in the next four weeks (between now and the December 21st delivery date).  The end of all bull markets is characterized by significantly bullish news, and this time is no different.  Given that the fundamentals of copper do not support the current copper price, my guess is that copper prices will decline substantially throughout 2006, and possibly beyond.

Finally, this author still contends that one of the sectors to avoid is the oil and gas sector - given that energy supply is now ample and given that bullish sentiment is still prevalent in the sector.  Unless the U.S. and Western Europe experience a cooler-than-expected winter in the next few months, energy prices should continue to trend down in the weeks ahead - especially since the growth of Chinese import of crude oil is still projected to be relatively flat for the foreseeable future.  For now, the market should continue to hold well over the next six weeks, even though in the short-term, it is still very overbought.  Investors or traders who want to go long here should be very selective with their positions - and given that this cyclical bull market is now very mature, one should always continue to be vigilant.  For now, we will continue to remain neutral in our DJIA Timing System, especially since it has been the weaker index for the last two years.

Signing off,

Henry K. To, CFA

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