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September 26, 2009

Copper Panic and Recovery
by Adam Hamilton

Although copper is not the largest base-metal market (aluminum is way bigger), nor the most valuable of the primary base metals (nickel is worth several times more per pound), it is still arguably the most important base metal. As the base metal of choice for investors and speculators, copper's price offers great insights into how traders view the global economic outlook.

With copper prices so heavily dependent on mainstream sentiment, it shouldn't be a surprise that copper was brutalized during last autumn's stock panic. That fear bubble led to the biggest and fastest copper plunge ever witnessed! But right after the panic's sentiment maelstrom passed, copper started recovering. That trend continues to this day, creating great opportunities in elite companies mining this critical metal.

Every long-term investor should own the world's best copper miners, as their stocks' appreciation potential in the coming years is vast. And every speculator ought to consider trading copper stocks, as they tend to mirror and nicely amplify moves in the broader stock markets. In order to understand why copper stocks are so compelling for all traders, you have to first consider copper's epic journey over this past year.

Like a picture being worth a thousand words, there is no better way to understand price action in its all-important context than by digesting a well-crafted chart. To chronicle copper's wild ride that led to today's great opportunities in copper stocks, I charted the last few years' price action below. It is amazing, something never before witnessed in copper's entire history.

Back in early 2006, the young copper bull suddenly exploded higher on a 130% year-over-year surge in Chinese copper demand. Between late February and late May that year, copper rocketed 90.8% higher in just 12 weeks! This stunning vertical ascent averaging 1.5% per day looked like a parabolic blowoff, an unsustainable speculative mania.

Indeed copper hit its $4.08 per pound all-time high then, a far cry from its bull's humble origins near $0.60 in November 2001. After this 574% bull climaxing in a parabola, there had never been a better time for a copper crash. And while copper did indeed fall sharply, and then continue correcting until February 2007, it didn't return to its pre-parabola levels around $2.25. Real demand, not just speculation, was driving it.

Starting from that early-2006 parabola and its aftermath, copper established the strong multi-year uptrend rendered above. It spent a lot of time up near resistance while periodically swooning to bounce off support. But despite this characteristic volatility, over a period of years copper was inexorably and relentlessly climbing on balance. The best directional indicator of any prevailing long-term trend, a price's 200-day moving average, was moving higher in copper.

Not only was copper's multi-year uptrend well-defined, its 2-year pre-panic average price ran $3.38 per pound. If a price level can be sustained for years, there is real demand underlying it. Artificially high prices driven purely by speculation are built on a foundation of sand and seldom last longer than weeks or months on the outside. Global copper demand was simply growing faster than the global mined supply.

These high copper prices, which persisted for so long for fundamental reasons, establish the baseline from which the stock panic's anomalous impact can be measured. It is critical to realize that late 2008's copper plummet didn't happen after a parabolic surge to unsustainable heights. While definitely on the high side of its multi-year range before the panic hit, copper had done nothing technically to warrant an epic crash.

By early July 2008, copper came within a penny of its all-time high from 25 months earlier. Commodities in general were thriving, with oil in the $140s and the flagship CCI commodities index hitting an all-time high. But there was no irrational exuberance in copper. A price just approaching levels it first achieved over 2 years earlier, and that had held again for 4 months prior to early July 2008, is simply not extreme.

After the biggest and fastest upleg of this entire commodities bull by far, commodities were certainly due for a healthy correction in summer 2008. Indeed, over the next 2 months or so copper fell 23.6% to return to its multi-year support. This was nothing to fear, as copper had seen similar corrections and subsequent bounces near support in both late 2006 and late 2007. The commodities and copper corrections, in normal conditions, would have ended in early September 2008.

But as you know, at that fateful moment in history a bond panic was morphing into the first stock panic seen in 101 years. Many commodities, and the CCI itself, were at their secular support lines. And as stock-market fears ballooned to breathtaking extremes, capital fled all risky assets at a staggering pace. Much of it flooded into the US dollar and short-term Treasuries, driving the biggest and fastest dollar rally ever witnessed which seriously exacerbated commodities selling.

This panic dynamic of fleeing everything to buy dollars is exceedingly important to understand. Last month I wrote an essay explaining its impact on gold. I highly encourage you to read it if you haven't, as this was the very same culprit behind the plummeting copper price. The stock-market fear, via the middleman of the dollar, ultimately crushed gold and the entire commodities complex.

As a metal heavily dependent on prevailing sentiment and consensus economic outlook in the best of times, it shouldn't be surprising that copper was hit abnormally hard in the worst of times. By the time the dust from the panic settled in late December 2008, copper had plummeted 68.6% to $1.28 per pound! Such an epic decline in copper was unheard of.

While there have indeed been a handful 35% to 40% retreats in copper in the last four decades, hemorrhaging 2/3rds of its value in less than 6 months was mind-boggling. Copper's stunning return to October 2004 levels didn't make sense even at the time. In the heart of the stock panic even before copper bottomed, we bought and recommended a new long-term investment in one of the world's greatest copper miners. There was simply no way such dismal copper prices were sustainable. As of this week, our newsletter subscribers are already up 152% on that copper-stock investment.

Provocatively, copper essentially bottomed the same day that the stock panic ended. The panic was defined by fear exceeding 50 on the VXO S&P 100 implied-volatility fear gauge, which it did continuously from October 2nd to December 18th. Copper hit $1.28 the very next day, as stock-market fear started to abate traders returned to this metal. While it would grind slightly lower (0.5%) to a secondary low a week later, for all intents and purposes copper bottomed the very day the stock panic formally ended!

Since those depths of despair, copper has indeed staged a dramatic recovery as expected. As of late August, it was up 129.7% from its panic low! After such a big and fast run, many analysts are concerned today's copper prices are unsustainable. But again context is crucial. As you can see above, copper remains low relative to both its pre-panic uptrend and pre-panic multi-year average price of $3.38.

Now there is no doubt that the post-panic world will be different than the pre-panic one. So it may indeed be years before we see $4 copper again. But just because of a stock panic, a purely psychological event, economic activity doesn't cease or become permanently crippled. All over the world people are still building and consuming, and the global population is still growing. Global demand for copper will remain high relative to history.

I don't know exactly where this puts the copper price going forward, but I bet it will be a lot closer to pre-panic levels than its panic lows. Consider the economies of its largest consumers, China and the US. Despite all the sound and fury in this past year encompassing a stock panic, US real GDP is only down 3.9% year-over-year. I realize housing has been hit particularly hard, but still US copper demand can't have plummeted too far when our economy is still trucking along at 96% of Q2 2008's pre-panic levels.

And Chinese GDP is actually growing despite the panic! In the year ending Q2 2009 that obviously straddled the stock panic, Chinese GDP actually grew by an amazing 7.1%! Chinese copper imports this year have risen to records in some months. Given the state of the world economy, copper demand (and hence prices) is likely to be far closer to pre-panic levels than the panic lows going forward.

This is relevant to copper stocks because most of their prices are still discounting a future copper price closer to the panic lows than pre-panic levels or even today's price. Thus the copper stocks, despite their sharp runs higher since the stock panic, remain fundamentally undervalued today. Until investors realize $3+ copper is going to be the new norm instead of the $2ish levels they are betting on, copper stocks are cheap. Interestingly, hard fundamental data buttresses this bullish copper-price outlook.

Copper, and the rest of the major base metals, are unique among commodities in that fundamental data is available daily. The London Metal Exchange coordinates a global network of warehouses that act as a buffer between copper consumers and copper miners, like an emergency supply. The LME publishes their total copper stockpiles daily, which are an extremely valuable trading tool as my business partner Scott Wright's research has abundantly proven.

In a nutshell, most copper mined is sold directly to factories manufacturing copper products for consumption. It does not pass through LME warehouses. But if a producer temporarily mines more copper than it is under contract to provide, it can ship its excess to an LME warehouse. And if a consumer temporarily needs more copper than it is receiving, it can buy directly from an LME warehouse. Thus the LME warehouse stockpiles, while existing at the margins, offer an excellent window into global copper supply-and-demand trends.

I'm including the following LME copper stockpiles chart in this essay because it offers illuminating insights into the panic selloff and subsequent recovery. Despite claims the copper bears made at the time and still to this day that copper's decline was fundamentally-justified, the panic selloff in copper was largely sentiment-driven. There was no fundamental basis for the lion's share of copper's panic weakness.

The LME stockpiles were clearly the primary driver of the big intra-trend swings in copper in its multi-year pre-panic uptrend. When stockpiles fell towards 100k metric tons, copper rallied up to resistance. And this makes sense. A tighter market makes copper much less resistant to any supply disruptions (like labor strikes or government meddling at major mines). With global demand running about 50k tonnes per day, LME stockpiles of 100k tonnes only provided a 2-day buffer! Naturally this led to a big speculative premium in copper.

And conversely as LME stockpiles grew, copper tended to retreat back down to support. For years prior to the panic, LME stockpiles slowly meandered between 100k to 200k tonnes. And copper's inverse correlation to these stockpiles' behavior is quite clear. At Zeal we used this relationship to profitably trade elite copper stocks in our subscription newsletters. Strategically, LME stockpiles often drive copper prices.

With this perspective in hand, consider the events from July to December 2008 when copper plummeted. In early July when copper topped along with the entire commodities complex, LME stockpiles indeed started building. And by early September when copper had made a normal intra-trend correction and was stabilizing at support, its LME stockpiles were also stabilizing near 200k tonnes at the top of their multi-year range.

Copper should have bounced here, and would have in normal market conditions. But right at this critical inflection point the panic fear started bleeding into copper and poisoning its sentiment. Copper broke below its own support near $3.10 or so in late September. At the time LME stockpiles were still running around 199k tonnes. As the stock panic intensified, so did the copper selling as speculators abandoned all risky assets.

By late October, the copper price had plummeted 35.2% in less than 4 weeks! It was a bloodbath. Yet did the LME stockpiles justify such a decline? Not even close. Midway through this span, they were actually dead flat at 199k tonnes, which would have been neutral in normal circumstances. And by late October, they were still near 206k tonnes or up just 3.5% over the short span of time where copper lost over a third of its value!

Witnessing such a wicked copper plunge during a span where the stock markets were plummeting yet stockpiles were fairly flat really highlights the sentimental nature of this metal's panic selloff. Copper was not falling because there was any fundamental reason for it to, but simply because traders were scared. The fear splash-damage from the stock panic was so great that everyone everywhere sold everything (except US dollars and Treasuries), including the futures traders driving the short-term copper price.

Eventually in late October when copper was already under $2, LME stockpiles did indeed start building rapidly as you can see in this chart. So you could make the case that copper's decline from $2 to its panic lows (337k tonnes that day) was fundamentally justified. But the $3 to $2 plunge leading up to that LME build certainly was not. I would argue a contrary position, that the big slowdown in copper demand leading to this build was also psychological and the direct result of the bleed-over worries from the stock panic.

Remember, in the first 19 trading days of October the flagship S&P 500 US stock index plummeted 27.1%! Over this same span, copper plummeted 42.6% while its LME stockpiles merely grew 7.4% to 213k tonnes. At the time, virtually everyone was caught up in the panic psychology and assumed a new Great Depression was dawning. While always a silly thesis (the Zeal Intelligence published in late November refuted it), imagine the depression fears' impact on copper-consumer psychology.

If you owned a factory fabricating products out of copper, and you saw the Armageddon-like implosion of the markets in October, you would have been very worried about your future sales. This alone would have caused you to reduce production forecasts and hence your copper orders. On top of this, with copper prices in a freefall you would naturally want to wait before locking in future copper orders. Why buy now when you might be able to pay 20% less a few weeks later?

I suspect this dynamic is why LME copper stockpiles started soaring so dramatically in late October in the heart of the stock panic. If this was the case, if panic psychology drove the temporary slowdown in copper demand, then the cause of the stockpile build was largely sentimental as well. This makes the continuing copper selloff in November look even more anomalous despite the soaring LME stockpiles then.

The copper price recovery supports this stock-panic-sentiment thesis. When copper bottomed in late December, there were 337k tonnes in the LME warehouse network. And stockpiles just continued growing from there, peaking at 548k tonnes in late February. Nevertheless, over this post-copper-low span where LME stockpiles rocketed by a very bearish 62.6%, copper itself climbed 19.2% higher. The LME build was certainly a stiff headwind, but the copper prices were so anomalously low in the panic that it didn't matter.

Since their late-February highs the LME stockpiles have rapidly fallen, normalizing back towards pre-panic levels. I suspect this trend will continue on balance in the coming year despite the recent stockpiles surge. Note that Q3 and Q4 in pre-panic years usually saw builds as well, so there is some seasonality at play here. The key point is copper stockpiles are normalizing towards pre-panic levels which means copper prices will too. So $3+ copper in the coming years is far more likely than $2ish copper.

Despite the panic's crushing impact on copper and copper miners' stocks, I still believe these equities are the best way to play this secular copper bull. They have immense profits leverage to copper prices. If a company can mine copper at $1 per pound, and sell it at $2, they have a $1 profit. But if copper rallies 50% to $3, the miner can still mine at $1. So its profits soar 100% to $2 per pound, leveraging copper's own gains by 2x. And ultimately profits drive stock prices, and copper stocks aren't even close to reflecting $3 copper.

At Zeal we've been actively trading this copper recovery, and we've used the recent strength to realize huge copper-stock gains (90%ish) in a matter of months in both our monthly and weekly newsletters. And despite copper and its miners getting sucked into the stock-market pullback in the coming weeks, the stocks' potential remains great in the months ahead. In fact, we've spent the last several months painstakingly uncovering our favorite copper miners.

Just this week, we published a comprehensive fundamental report profiling our favorite dozen base-metals stocks. We started with the universe of all the publicly-traded base-metals companies in the US and Canada, and gradually researched each to whittle down the big list to our favorites. These are the elite companies we feel have the best odds of thriving in the coming years due to their stellar fundamentals. These are the stocks we are trading ourselves in our acclaimed newsletters. (Subscribe today for world-class research and trades!)

Of our dozen favorite base-metals stocks, half produce copper today and another two are developing high-potential copper projects. While most of these companies mine other metals as well, there are some fantastic primary copper stocks profiled in our fascinating new report. While it took us hundreds of hours to research and write, we are selling this entire new 34-page report for just $95 ($75 for Zeal subscribers). Buy your report today and prepare to ride the copper recovery and ongoing bull!

The bottom line is the stock panic sucked in copper prices too. Despite its favorable fundamentals, copper couldn't withstand the fear maelstrom. The collateral damage was unbelievable, as the unrelated stock panic drove copper's biggest and fastest losses ever witnessed by far. Of course this was all an unsustainable anomaly like everything else in the panic, an extreme condition that couldn't persist without epic fear.

So once the stock panic ended and fear started abating, copper immediately started recovering. Despite its big gains since its panic lows, it remains well under its pre-panic uptrend. Given its fundamentals, this recovery should continue. And since most copper stocks' prices are discounting copper closer to the panic lows than today's levels, great opportunities exist in these miners. Eventually they'll reflect $3+ copper.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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