As China’s economy begins to cool from blistering 10%-12% annual growth rates down to 6%-8% growth rates, commodities have lagged the broader market. Last week, I took a look at the bearish nature of the gold market based on a technical thesis with a rising US dollar. Today, I effort to pose an investment thesis for copper over the coming 3-4 months.
Copper is typically deemed as the only commodity to have a degree in economics because it historically has been the best indicator of future economic growth around the world. For this reason, those who are bearish on the global economy as a whole can use copper as an investment vehicle. Copper has shown little long term effect from quantitative easing from central banks around the world. Where stocks can rise in the face of economic turmoil due to outside stimulus, copper is more likely to accurately reflect the state of the global economy. Below are my top 3 reasons why copper is set to go lower over the coming month.
Reason #1: One of the most solid bearish arguments for copper can be made on the thesis that China’s economy is cooling as is not likely to see the 10%-12% annual growth numbers again. Donald Straszheim, Senior Managing Director of China Research with ISI Group, said, “The boom days (in China) are almost certainly over. I think China’s growth rate is slowing and slowing a lot. And the old era of 10 percent growth is going to become the new era of 6 percent growth. So the world is going to begin to absorb the idea that there’s going to be weaker demand for a lot of these commodities for a long time to come.”
Mr Straszheim’s argument is very fundamental in nature but is echoed from many around the world. Below are some of comments being made collected by Andrew Gordon in his article, ‘Can you handle the truth about China’.
- Average Chinese GDP growth this decade will not exceed 3% (Peking University Economics professor Michael Pettis)
- “A one-in-three probability” that China will experience a hard economic landing before the end of 2014. (Nomura, the Japanese financial services firm)
- “Some argue that China might already be in recession…” (Foreign Policy magazine article called “Five Signs of the Chinese Economic Apocalypse”)
- A “ghost fleet” of Chinese shippers plying the open waters in search of freight to transport, as if “out of the shadows.” (Evan Osnos, The New Yorker)
- China headed for a “hard landing of epic proportions.” (Jim Chanos, hedge fund manager)
- “China has all the earmarks of a classic mania that will end badly…” (Edward Chancellor from GMO)
- “Huge downward pressure” from slowing consumer demand in Europe and real estate speculation at home. (Prime Minister Wen Jiabao)
While China’s economy may or may not be headed for an epic crash, the days of supersonic growth are behind it. A major growth engine for the price of copper is drying up.
Reason #2: Long-term charts for copper are looking very suspect to further decline. The 1st chart below is a chart of JJC, the copper etn. Since the reflation of the markets in 2009, copper has failed to achieve gains. While bobbing up and down, the pattern is very clear. Most market technicians refer to it as a head a shoulders reversal pattern. A head and shoulders pattern is an rather accurate pattern seen ahead of a major reversal. The present head and shoulders pattern has not yet confirmed a breakdown, but another 1%-2% decline would break major support levels and signal a 12%-15% further decline in the coming months. The longer term implications of the pattern put the JJC below 30.
While the head and shoulders pattern is considered by many to be a voodoo like interpretation of a chart, an ABC correction pattern is more accepted in technical circles. An ABC corrective pattern typically happens after a long term rally. The ‘A’ part of the move is the initial selling or profit taking seen in the 1st half of 2011. The ‘B’ move is where buyers step back in as they feel the stock or commodity is oversold as seen in the latter half of 2011. At present, copper is in the midst of a ‘C’ move. The ‘C’ move can be the longest, most drawn out move that typically retraces the long term rally by 62%. If copper keeps with its present ABC corrective pattern, the price target is around $35, similar to the head and shoulders target seen above.
Reason #3: The US dollar and Copper are negatively correlated. A negative correlation suggests that when one thing rises, another falls. This is the case with the US dollar and copper. Historically, when the dollar rises copper falls and vice verse. There are many technical signs suggesting a rising dollar which naturally suggests falling copper. In the chart below, the negative correlation is evident but with 3 key exceptions. All 3 exceptions revolve around quantitative easing programs by the US Fed. When the easing programs were put into play, the correlation between copper and the dollar became very little but when the programs effects wore off the negative correlation returned. Given the presidential election in the US is only a few months away, I doubt the US fed is going to enact anymore QE programs for fear of being deemed as influencing the elections. (more to come on this topic)
The Trade: Given the bearish arguments for copper, what is the trade? There are several options.
- Buy the 2x inverse etf for copper, SCPR. It will rise as copper falls at approximately twice the rate.
- Buy put options on JJC. The spreads on these puts are large so I would suggest deep in the money puts at limit prices where the spread is reduced. For example, the DEC 12 60 puts for $17-$17.50.
- Put options on copper miners. These can be a bit more tricky in a rising stock market but pay off big if stocks and copper fall together. FCX and SCCO are solid candidates.
Technical confirmation of a downside trade is had with a move below $41.50 on the JJC. The bearish technical thesis on copper is severely compromised if copper moves above $3.55 or $45.5 on the JJC. These levels can be used as stopping points to minimize risk. With 12-15% reward potential on the downside and 4-5% risk, the 3:1 reward to risk ratio makes for a solid trade.