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2012 Outlook on Base Metals

(January 15, 2012)

Dear Subscribers and Readers,

Let's begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

We last discussed our short-term outlook on base metals in our August 7, 2011 commentary (“The ECB Needs to Ease”) when we implied that base metal prices likely had further to fall, given the weakness in crude oil prices and the fact that the ECB were not willing to ease monetary policy. Since then, base metal prices have corrected, and not too surprisingly, the ECB has stepped up—through lower rates, unlimited three-year loans to European banks, and sterilized purchases of Italian and Spanish sovereign debt—while interestingly, WTI crude oil prices have risen from $84 to around $100 a barrel.

With the People's Bank of China now starting to ease there is not much danger of another downward spiral in base metal prices. Indeed, while the Chinese construction market (the main Chinese consumer for base metals) is still struggling, there are good indications that the sector will grow in 2012—driven by a rise in social housing construction (which is needed to alleviate social inequality), and which is expected to extend into 2013. At the same time, the strength in the US Conference Board leading indicators suggests US demand for base metals, such as copper and aluminum, will stay resilient this year.

In addition, the recent decline in global US$ liquidity had resulted in some destocking of European base metal inventories, especially in copper. This is evident in the following chart (courtesy of showing the recent decline in LME copper warehouse stocks:

The recent decline in LME copper inventories is bullish for copper prices. Also, with the copper market expected to remain in deficit this year; and with smaller Chinese aluminum producers being reined in by the government (in order to reduce the energy-intensity of its industries), our 2012 outlook for copper and aluminum prices is bullish. This comports with the recent action in WTI crude oil prices, which is a significant input to copper and aluminum production. Our 2012 crude oil price forecast (an average of $105 to $110 a barrel this year) is also supportive of our bullish view (high enough to cause a rise in cost of production; while not sufficiently high to adversely impact global economic growth).

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:

For the week ending January 13, 2012, the Dow Industrials rose 62.14 points, while the Dow Transports rose 106.89 points.  Both the Dow Industrials and the Dow Transports made fresh six-month highs—which is technically bullish. More important, the contagion risks from the European Sovereign Debt Crisis have diminished (although the Greek debt talks still need tracking), given the ECB's renewed commitment to reliquify the European banking system, the availability of the Fed's cheap US$ swap lines to the ECB, as well as the resilience of the US economy. We remain bullish on US and US financial stocks, but given that we are dissolving the end of February, we will not make any more moves in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators increased from 12.2% to 16.4% for the week ending January 13, 2012.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:

Since hitting a multi-year low of -11.3% in early October, the four-week MA has surged by 27.7%. The four-week MA is now overbought in the short-run—as such, we wouldn't be surprised if the market corrects over the next couple of weeks. That said, it is still at a neutral level in the long-run  With the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines and the resilience of the US economy—we continue to look for a rally in US stocks and US financial stocks over the next several months.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

Ever since breaking 100 in mid-December, the 20 DMA has been on an upward tear, and remains solidly above its 50 DMA. Such a breakout from a highly oversold condition is definitely bullish—all the more so since the risk of a Euro break-up scenario has diminished. We remain bullish on US stocks and US financial stocks.

Conclusion: We are looking for higher global copper and aluminum prices this year, given an ongoing deficit in the former, and the Chinese government intent to clamp down on aluminum production of smaller Chinese producers. In addition, the ECB remains in easing mode, while the Chinese construction market should experience ongoing growth given the Chinese government's commitment to building social housing.

Signing off,

Henry To, CFA, CAIA

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