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Henry To

Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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Copper in the Midst of Topping Out

Below is an extract from a "subscriber's only" commentary originally posted at marketthoughts.com on 20th November2005.

Dear Subscribers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. For now, we are completely neutral and in cash. Even though in the short-run, the market is very overbought and should be subjected to a correction anytime now, it is still in an intermediate uptrend for now - a trend that should last until at least the end of this year. This author, however, does not recommend committing substantially on the long side, given that many of our longer-term indicators are now rolling over, such as our MarketThoughts "Excess M" indicator, as well as the fact that both the U.S. Federal Reserve and now the European Central Bank remain in a tightening basis at least until January of next year.

Talk about the dangers of "showing your hand" in poker and in the financial markets. Starting with our November 6th commentary on bonds, we argued that retail investors were "showing their hands" in various markets such as the energy markets, and the stock market in general. We also discussed the inherent danger when one "shows his hand" in the financial markets - said strategic mistakes which had resulted in the demise of Long-Term Capital Management in the Fall of 1998 as well as the near-demise of Enron Oil in October 1987. Readers who are familiar with financial history should know this: When one is stuck with a large, illiquid, and levered position that is a bet against the current prevailing trend, chances are you're already 90% of the way towards bankruptcy. The 1997 Zhuzhou short squeeze in zinc was one major example. A more recent example is the demise of China Aviation Oil in late November of last year.

So Henry, how does this argument relate to the current trend in copper prices? And how do the 1997 Zhuzhou Smelter and the 2004 China Aviation scandals come into play?

Let's now answer the first question. In our September 18th commentary, entitled: "Copper Prices - Too Overbought" we first discussed why copper prices were very overbought and why they were close to topping out. We discussed that real estate prices and transactions were declining in China, the U.S., the UK, and Australia. With regards to the US, we discussed the dismal performance of the homebuilding stocks as a good indicator of potential declining demand, as well as lower demand because of declining automobile sales. Since our September 18th commentary, none of these bearish factors on the demand side have changed. If anything, the declines in copper demand have continued. In the major real estate markets in China, real estate prices have declined further and transaction volumes have literally collapsed. Moreover, the major homebuilders listed on the U.S. stock exchanges have been consistently missing their earnings targets - something that had been unheard of for the last three years until recently. Finally, new vehicle sales for the first 13 days of November is still down 15% on a year-over-year basis, after declining by 33% in October - this despite recent declining gas prices since Hurricane Katrina hit a few months ago.

Indeed, even though copper warehouse stocks on the London Metals Exchange (LME) have again declined since our September 18th commentary, readers should note that warehouse stocks (following chart courtesy of Kitco) are still 160% higher than where they were back in late July/early August earlier this year:

1 Year LME Copper Warehouse Stocks Level (Nov 18, 2004 to Nov 18, 2005)

The problem with this analysis, however, is that a 63,800 ton inventory is really trivial in the grand scheme of things - given that China alone consumes 3.5 million tons of copper every year. More importantly, however, is the recent speculation that a certain Chinese metals trader working for China's State Reserve Bureau has a near 200,000 ton short position in the metal - set for a delivery date of December 21st. Readers who are interested can go to the "market commentary" section in our discussion forum and browse through my posts on copper for more details.

It is important to keep in mind that many reporters who are currently writing up the article are still speculating at this point. The official news coming out of the Chinese government right now is still pretty sketchy. For example, the spokespeople at the LME have gone on record and stated that they believe the markets will remain orderly; if any trader is short 200,000 tons of copper and do not have the ability to deliver that obligation by December 21st; then the markets will definitely not remain orderly. Such a trade (piling 200,000 tons into one contract) also does not make logical sense, as any potential upside is limited while any potential downside will be huge. In the very short-run, however, all that matters is perception and sentiment. This author is now looking for a possible short trade in copper (although this definitely should not be interpreted as investment advice). Assuming that the "worst-case scenario" occurs and the Chinese government is on the hook for the 200,000 short position, there is no question that the cash price and the December contract will go sky-high in the next four weeks. In such a scenario, I would not be surprised if we see a $2.50 or $3.00 per pound cash price on the NYMEX if such an event did occur. Keep in mind that the cash gold price ran up from $400 to $850 an ounce in a matter of seven weeks before it finally peaked in late January 1980. We had a similar "blowoff" situation in the NASDAQ in 2000 although it took a longer time to run. The great thing about the current copper situation is that we more or less know the timeframe (that is, the delivery date). I remember shorting the NASDAQ starting in late January 2000 and for the next six weeks, I was literally sweating bullets. If one was off ten days in shorting gold in January 1980, he or she would have literally gotten killed since the gold cash price ran up from $600 an ounce to $850 an ounce during that period. Such a case should not happen with the current copper situation - given that the Chinese government has more or less "shown their hand" with regards to the delivery date.

That being said, no one would be foolish enough to short the December 2005 contract. However, my guess is that any run up in the cash price and the December 2005 contract would "pull up" the March 2005 and the May 2005 contract as well - and those are the contracts that this author is looking at very closely right now. After this run-up and after December 21st, the ensuing collapse should happen just as quickly, as I don't believe the fundamentals support the current price of copper (nor the prices of copper over the next 12 months as implied by the current futures contracts). Numbers and statistics by official agencies are fine, but my "gut feel" feels otherwise.

Moreover, bullish sentiment, as measured by the Market Vane's Consensus, is at extremely bullish levels - usually a good contrarian indicator. In fact, the latest weekly reading of the Market Vane's Bullish Consensus for copper came in at 89% - the highest reading since early October 2005, and prior to that - May 1997. Moreover, the 21-day moving average of the Market Vane's Bullish Consensus just touched a reading of 84.8% - the highest reading ever recorded for this indicator. Following is a chart showing daily copper spot prices vs. the 21-day and the 55-day moving averages of the Market Vane's Bullish Consensus:

Daily Copper Spot Prices vs. Bullish Sentiment (January 2003 to Present) - Copper spot prices hit an all-time high in the wake of Hurricane Katrina, and this has continued over the last three months.  Interestingly, the bullish sentiment in copper has not had a significant correction (21 DMA below 70%) since January this year - suggesting that copper is hugely overbought.

Please note that since our September 18th commentary, bullish sentiment has continued to climb - with the 21-day moving average of the Market Vane's Bullish Consensus now at 84.8% and having never declined below the 70% level since ten months ago. "Bullish" news like the possible squeeze of the Chinese government - combined with declining fundamentals and high bullish sentiment - usually coincides with a bull market finally topping out. Recent and historic examples include the shut-in of 80% of Gulf oil production in September earlier this year, the $1 trillion market cap call for Cisco in March 2000, as well as the cornering of the silver markets by the Hunt brothers in late 1979/January 1980. I don't believe that things are different this time. My guess is that the topping out of copper prices within the next few weeks is inevitable.

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