by Kevin Klombies, Senior Analyst, TradingEducation.com, LLC


Monday, August 4, 2008

Chart Presentation: Copper

Aug. 1 (Bloomberg) — Copper fell the most in three weeks as a rally in the dollar and expanding inventories of the metal increased concern that demand is waning.

In general copper and crude oil prices trend together and, in general, copper tends to lead crude oil at major trend change points. In general Asian and emerging equity markets do better when copper is stronger than crude oil. We will argue that weakness in Chinese equities and strength in the Kuwaiti stock market indicates that we have reached the point in the commodity cycle where copper prices have started to decline in front of energy prices.

In general rising copper prices go with higher long-term interest rates while falling copper prices will tend to go with declining yields and stronger long-term bond prices. In general the trend for copper and crude oil combined is the mirror image of the trend for the combination of the U.S. dollar and TBonds.

The chart below compares copper futures with the ratio between Caterpillar (CAT) and Pepsi (PEP).

Through the first half of this year the markets pushed copper prices upwards while favoring cyclical stocks such as CAT over defensive names similar to PEP. At the end of last week there was just enough weakness in copper and the CAT/PEP ratio to suggest that the equity markets trend through much or all of the second half of the year will favor those sectors that do better with weaker cyclical growth, a stronger dollar, and declining long-term interest rates.

To put the current situation into some form of perspective the chart at bottom right shows the ratio between the share price of Coca Cola (KO) and copper futures.

The KO/copper ratio peaked in 1998 just above 1.2:1 as copper fell close to 60 cents while KO traded up into the high 80’s. With copper today around 3.62 and KO in the vicinity of 53 the ratio is closer to .15:1.

The point is that the Coke versus copper trend tends to run for a very long time. The ratio rose for ten years from 1988 into 1998 and then declined for an additional ten years from 1998 through into 2008. If the trend eventually turns positive once again we would expect that it would remain positive for quite a few years.

Below we show a stacked comparison that begins at the bottom with heating oil futures.

In 2004 heating oil futures finally broke to new highs through the peaks set in 2000 and the spring of 2003. As energy prices rose there was upward pressure on U.S. short-term interest rates.

As interest rates began to climb the trend for lumber futures turned negative. Lumber futures peaked in mid-2004 and subsequently bottomed early in 2008.

Some time after lumber prices turned lower the share prices in the forest products sector began to weaken. We show Canadian lumber producer Canfor (CFP) in the comparison.

In late 2005 the U.S. home builders finally reached a peak before turning negative. A year later weakness in the U.S. real estate market began to weigh on the financials so that the stock price of Citigroup (C) began to decline.

The argument is that strength in energy prices in 2004 helped push interest rates higher and tighten credit conditions and over the next few years this led to weakness in lumber, forest products, home builders, and then the financials. By late 2007 the Chinese stock market finally turned lower but recent strength in lumber futures and an apparent peak in energy prices suggests that the cycle is in the process of starting anew as lumber prices lead to the upside.

Below we feature a comparison between copper futures and the price spread or difference between the 30-year and 10-year Treasury futures.

In general- and we have used this term often today- weakness in copper prices goes with a rising spread. In other words as copper prices decline 30-year Treasury futures prices will rise relative to 10-year prices. A rising spread typically goes with a bullish trend for bond prices.

Kevin Klombies is a prolific writer and market analyst specializing in the commodity stock market and bond commodity market trading in the energy sector. He  graduated in 1980 from the University of Saskatchewan with a Bachelor of Commerce degree (Honours) in Finance/Economics.  Click here for full bio >>