My natural tendency is to look for excuses to play the market and its components lower. That said, I am having a difficult time trying to convince myself to get short after last week’s rally. The #1 reason has to do with the US dollar. No matter how I slice it, the dollar from a technical point of view, is poised to go lower. In the chart below, we can see some of the pattern setting up. The most bullish thing I can say on the dollar is that it may be set to consolidate slightly over the coming weeks.
Historically, a lower dollar leads to rallies in stocks and makes it more advantageous to play the upside in the market. Metals tend to perform the best when the dollar is falling and stocks like FCX and X are showing some interesting bullish patterns. I am looking at calls in the metal area into the close. I may wait til the morning to put a play on. I am waiting to see how the hourly charts set up into the close.
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.
After months of consolidation in the gold market, a very nice trade setup is happening. Short gold and long the US dollar. Historically these two asset classes are negatively correlated meaning that when gold rises, the dollar falls and vice-verse. While there are many fundamental arguments to a rising dollar and falling gold, the arguments are subjective and irrelevant when it comes to managing trade risk. Because of the subjectivity, my trade setup is simply a technical one in order to quantify my risk and set realistic price targets.
Below is a chart of the UUP which is an etf for the US dollar. The dollar hit a high in May/Jun of 2010 . Understanding that a rising dollar contributed very little to the US economy, the Fed set out to devalue the dollar through is quantitative easing polices. Currency markets responded by selling the dollar while gold markets watched the price of gold shoot up 40%. The quantitative easing policies have continued from the fed but the effects on the US dollar and gold are wearing off. This can easily be seen by the recent rally in the US dollar.
The chart pattern on the UUP is a rather unique but accurate rounding bottom reversal pattern. Rounding bottom reversals typically reverse slowly and gain momentum before shooting higher. Currently the dollar is building upside momentum and the tendency would be for a major rally to come.
I continue to be a dollar bull…at least for the coming 6-9 months barring any major technical changes. $22.25 becomes a nice stopping point for the bulls to manage risk while a price target of $24.00 would be rather conservative. Due to their negative correlation over time, a bullish view on the US dollar would naturally lead to a bearish view on gold.
The simplest bearish argument on gold is the fact that a multiple year downtrend was broken earlier this year as seen in the chart above. In the chart below, the retracement of the strong rally is noted. A 32% retracement occurred at the beginning of 2012 and gold shot higher as many who missed the 2011 rally used the retracement level to pile in. When that buying pressure ran out, gold ultimately failed to set a new high and broke its major up trend.
At present, gold sits back at its 38% retracement level with many signs pointing lower.
- major uptrend broken – already discussed
- typically when a 38% retracement acts as support once, it fails to act as support again.
- when the 38% retracement fails, a move to a 62% retracement is common.
- after an explosive rally as seen in 2011, a move back to a normalized trend is typical. (as seen in the blue dotted trendline)
While gold sits at its 38% retracement, it is consolidating. This consolidation began in May and is still taking place. This consolidation is part of the natural movements in stocks where they consolidate then trend. One way to spot a coming trend or consolidation period is by using the ADX. After a stock has consolidated, the ADX is typically low. When the trend phase begins, an upturn will be seen in the ADX. When a stock has been trending and is ready to consolidate we typically see a downturn in the ADX. Its important to note that the ADX says nothing about directional movement. It just assists in recognizing when a stock is ready to move.
At present, the ADX on gold is extremely low. It has yet to turn higher so the consolidation phase of gold is still in effect. When the ADX begins to turn higher, a breakout in gold will follow. With the bullish nature of the dollar and the bearish technical aspects of gold discussed above, I expect to see a breakout to the downside. Confirmation of that downturn would be a move below 153 on the GLD. A move above 159 would negate some of the bearish technicals and can therefore be used as a stopping point.
With GLD sitting at $157.60, setting up a short position ahead of a potential breakdown may be premature but offers very little risk if the trade does not work. With a stopping point of $159, the risk is $1.40 with a reward potential on a breakdown in excess of $10.00.