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Copper Prices Blowing Off?

(December 9, 2010)

Dear Subscribers and Readers,

The bullishness in copper is getting deafening, as analysts rant on about age-old Chinese demand and supply issues—and of course, the impending creation of copper ETFs (especially with the recent JPM's $1.5 billion trade on the LME).  Bullish projections have the metal rising to the $4.50 to $5.00/pound range in the near future (the near-month contract is currently trading at $4.14).  Of course, anything can happen in the near-term (subscribers may remember that a Chinese state trader got caught with a massive copper short position in November 2005—and was forced to cover at exponentially higher prices).  If a large hedge fund or another trader is caught with a short position, then prices could easily blow past $5.00 a pound, especially given the speculation of inevitable ETF demand.

Technically speaking, copper isn't overbought either.  Based on LME prices, the price of copper is only 7.2% and 20.5% above its 50-day and 200-day moving averages, respectively.  For comparison's sake, the red metal peaked at over 40% and 80% above its 50 and 200 DMAs, respectively, at the end of its first major bull run in April 2006.  In other words, I am not shorting copper at current levels.

However, I do want to play “devil's advocate”—especially to those who want to “invest” in copper for a period of six months or over.  Firstly—as shown in the following chart—most other base metals are not confirming the all-time highs in copper prices, with the exception of tin prices:

Note that nickel prices topped out in summer 2007, lead in Fall 2007, and aluminum in summer 2008.  In fact, none of these three metals is currently anywhere close to their all-time highs.  This is important as copper prices in general have been rising (and last peaked) at the same time as prices of other base metals.  This price divergence in copper/tin with other base metals suggests that liquidity is either lacking or too focused in the base metal sector—definitely not a precursor for a sustained bull market in copper or tin prices.

Moreover (and as discussed in the above chart), Chinese leading indicators have kept on declining, as evident in the following chart courtesy of the OECD (the next set of leading indicators will be published on December 13th):

According to GaveKal, there exists a significant correlation between the Chinese LEI and base metal prices (with a 3-month lag).  This phenomenon is not unprecedented (subscribers should remember that commodity prices, unlike equity prices, are priced at the margins).  For example, base metal prices and the Japanese LEI also experienced a significant correlation during the 1970s as the latter kept industrializing on a larger scale and became exporter to the world.  With the Chinese LEI now clearly declining, and with the all-time highs in copper prices not being confirmed by other base metal prices, I urge subscribers to be very careful about going long the upcoming copper ETFs.

Finally, despite what most pundits are saying about copper “supply issues,” the official LME warehouse stocks is still high relative to the levels over the last five years.  In addition, there exist other inventories not accounted for in the official LME stocks, such as various Chinese inventories and any physical stocks being accumulated (if any) by the upcoming copper ETFs.

Signing off,

Henry To, CFA

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