Don't Try to Trade Copper; Use it as an Economic Indicator

A regular reader wants to know how to make money off my projected continued decline in the price of copper. The following was my response.


The best way to trade commodities is with a futures account, however, this is a specialized business filled with professional snakes. The commodities trading pit is not the kind of place where a modest investor would want to hang out.



The main point about copper is that the price decline shows that the market turn is happening and that inflation rates will soon fall, as the significantly lower price of raw materials work their way through the production cycle.


As noted, 1) stocks have historically appreciated an average of 350% more during times of declining inflation; 2) during a time of declining inflation, bonds normally appreciate first and then there is an overlap, where financial stocks gradually take over before consumer spending explodes.


Manufacturing recessions play out a little different than real estate recessions but since I presented the numbers for the last real estate recession earlier, I will go over the numbers from the last recession. In 1999 the S&P 500 Bank Stock Index fell from .32 times the S&P 500 Index to .18 times the S&P 500 Index. The total return for the year was 22.7% but the bank index underperformed the S&P by 44%. At the bank stock bottom in March of 2000, the Bank Index got down to 15.5% of the S&P.


The S&P 500 in 2000, 2001 and 2002 returned -9.2, -11.9 and -22% respectively. In 2003, the first good year after 3 down years, the S&P was up 30.7%. From the March 2000 bottom at 15.5%, the bank index soared. The nominal bottom of the S&P was on October 10, 2002. In other words, the -22% return in 2002 included a plunge to the bottom in October and a strong rally to year end. The bank index was going almost straight up before the S&P joined the move. By April of 2003, the bank index had reached 37% of the S&P. Over the next two years, the bank index performed in line with the S&P, but by June of 2006 the bank index was trading at 32% of the S&P.


From the bottom in March 2000 to the peak in April of 2003, the bank index outperformed the S&P 500 238%. Unfortunately I don't have the bank index total returns handy. The weak substitute I can offer is that while the S&P was down 9.2% in 2000, the broad Financial Sector was up 26.9%.


One problem with the 2000 recession numbers is that the events of 9/11 distorted the outcome. I should also note that the top performing sector in 2001 and 2002 and the second performers in 2003 and 2004 was the real estate sector. These broad based returns, from 2000 through 2004 were 27.6%, 11.7%, 3.6%, 36.9%, and 31.2%. As you can see, the person who invested in the right place, early during the 2000 recession, did very well. Indeed, if one put up 20% of total value to buy real estate in early 2000, one made about 130% return in 2000, a tough year when the average big stock fell 9.2%.


As noted, real estate recessions play out differently than manufacturing recessions. The industrial metals index was about 62% of the Gold index in early 2000. The bottom of 39% was not reached until March of 2003, right at the take off of the big Dow Stocks. The ratio was at 76% in July of 2007 and it is already lower than the March 2003 bottom. It was trading around .35 a few days ago. The above illustrates that this recession, being a real estate recession will see even bigger swings than the average recession. By the way, real estate gets hammered in almost all recessions; the difference in a real estate recession is that real estate drags the rest of the market down, whereas in a manufacturing recession, high interest rates and the loss of jobs drags down real estate.


In nominal terms, the massive decline, in the price of copper from July 2007 to today, was from $4.11 to $1.66. After such a massive decline, a one to 6 month bounce would not be a surprise. The market sometimes takes time to digest a move before following through with the "second leg". I believe the price will go below 50 cents but that does not mean one will automatically make high returns by shorting copper futures, by nature, futures tend to be short term speculations. The main problem with futures is getting the timing right. When one looks into the future, one always looks through a cloudy crystal ball. It is easy to be off a few months, which can turn a wonderful trade into a major loss.


The clear immediate future is stuff that is already "in the works". The lower price of raw materials, the move that has already happened, will translate into lower prices of goods as those prices flow through the production cycle. Gasoline being sold at $1.48 wholesale in Texas and Louisiana will not reach North Carolina for a few weeks. My local Shell station was selling regular at $3.04 last week and is down to $2.69 this morning but it is a solid bet that it will be selling regular at $2.08 within three weeks (perhaps 4.5 weeks to get past the Thanksgiving Holiday).


The reason economist call copper, Dr. Copper, is because its price gives us an indication of our economic future. However, one should not try to use a decline in the price of copper to predict a further decline in copper. While it is obvious that the demand for copper will remain low until there is a rebound in the economy, we must remember that the stock market also leads the economy. As I have noted before, the prices of commodities are a lagging indicator, similar to unemployment. We do not see the worst of unemployment or declining copper prices until after the economy is well into a downward path. By the time these measures are indicating that we are in a recession, it is time for stocks and real estate to start their recovery.


In September, we had the largest reported monthly jump in existing home sales in 5 years. It was the first time in 30 months that existing home sales were up year over year. A bottom is being made in housing. The first bounce may prove to be only a test but it is a great sign. We are in the third phase of real estate, when sales are rising even though average price is still falling. In North Carolina the foreclosure ratio fell 27% last month. Nationwide about 35% of all homes sold last month were deeply discounted foreclosures. The other 65% of the homes probably were sold at higher prices (perhaps well below listing prices but still at higher year over year prices). Foreclosure sales tend to be concentrated, more neighborhoods are stable than are collapsing.


The key measure, as always, is supply and demand. The supply of homes for sale has fallen 5 months in a row from 11.3% months to 10 months of sales. The reason real estate did so well in 2000 to 2004 was the supply hit 2 months in early 2000 and was still only 4 months when the real estate fireworks really started in 2005. The time to sell real estate was in 2005 or early 2006, when supplies were just ready to exceed 6 months of sales. With only a modest pickup in home sales, the current 10 months supply could fall quite rapidly. A significant number of rental homes for sale will come off the market when their owners realize the market has turned. Many potential buyers have hesitated to buy while prices are falling. The sales rate will jump when these buyers realize that prices are rising. Because it takes time to locate the best properties, it is important to start looking and to make offers well before prices start moving up. The attitude of sellers will be very different once they hear that prices are rising.


Building permits are very low. There is pent up demand that is frozen while potential buyers wait until they know their job is secure or when their bank is more willing to offer great terms. Just in a few weeks, the 30 year mortgage rate dropped from 6.5% to 5.9%, rallied to 6.4% and is now back at 6%. In normal times, banks would only charge about 1.5% more than the 30 year bond. The 30 year traded at 4.04% yesterday. Home loans at 5.5% would make many more homes affordable to many more people.


Please note that with the exception of a few economist, Art Laffer being among the concerned, a turn in labor costs is not being forecast. In the late 60's and early 70's, the labor movement had a strangle hold on business. Obama will move policies toward the failed strong union policies of the past, but not nearly as far as his liberal friends in congress will attempt to pass. In the 60's and 70's, government policy ultimately resorted to hyper inflation of goods and services prices in order to counter the extraordinary salaries being collected by workers. Real interest rates were kept negative, at least up until deregulation hit and Ronald Reagan fired the air traffic controllers. The run up in commodities prices that occurred in the late 70's was accompanied by a run up in labor costs. Businesses had a difficult time making real profits and by 1982 PE ratios were down to 7 times. As usual, when the pendulum swung the other way, it went too far. In 2007, the average executive got a 38% raise. In 2008, the average executive will see a 15% cut in pay. The market correction in executive pay has started. Art Laffer's concern is that the pendulum will now swing to big increases in minimum wages and in union membership growth. Unions bankrupted the airlines, the rail roads and Chrysler, GM and Ford are on the brink. The best solution for GM would be to file Chapter 11 bankruptcy in order to get out from under outdated union contracts and dealership franchise laws. The more likely scenario is another government bailout.


This time is different! Dangerous words but labor in India, China and elsewhere is plentiful and technological innovations are reducing the cost of labor per unit of product even more. Obama's protectionist rhetoric was political rhetoric. He is not likely to push hard enough to end previous free trade deals.


Back at the start of the 80's, inflation rates fell dramatically as both the price of commodities and the price of labor came down. This time, inflation rates never got to extreme levels, even with the price if copper going more than 800% in a few years. This time, inflation rates will come to even lower lows. The unions who have spent billions of workers dues on support for Obama still face the new economy where robots do our manufacturing and where the low cost region is where the work gets done. By the way, Toyota will export trucks made in Tennessee to Latin America.


I say again, the average monthly return on stocks during times of declining inflation rates is 1.17% compared to .33% during times of rising inflation. Bonds will move first, financial stocks next and consumers will buy like crazy after they start seeing the price of things like Coke (corn syrup) fall dramatically. Just as the talk of GM bankruptcy gets the most play, there will be a massive shift of consumer spending from gasoline, energy and inflated food prices to consumer durable goods.