The copper market is widely accepted as a forecasting tool, often called Dr. Copper for its ability to diagnose sick stock markets before they collapse and require drastic life-saving measures.
But copper did little to warn stock investors in 2007. Take a look…
Copper was still making higher highs and higher lows throughout 2007, signaling a bullish trend was still in force. Meanwhile, the Dow Jones Industrial Average (DJIA) was ending its uptrend in 2007 by printing successively lower highs and lower lows.
It’s likely the U.S. property bubble is to blame for copper’s inability to forecast the stock crash of 2007 to 2009.
The theory behind copper’s use for forecasting stock returns is this: Copper is used to build homes. So higher demand for copper means there’s a higher demand for homes. Higher demand for homes is indicative of a healthy, growing economy. And stocks typically perform well when the economy is healthy and growing.
This is a logical theory, albeit one that’s clearly imperfect. A reliance on copper alone seems too simplistic.
After thinking on this conundrum for a while, I thought: “What if I divided the price of copper by the price of gold? Maybe that’s a better predictor of turns in the stock market than copper alone.”
My thinking was this…
Copper markets will be weakest when the business cycle is weak.
Gold markets will be strongest when investor sentiment is weak… that is, when economic and geopolitical conditions make a global financial crisis seem imminent.
So a gauge that takes into account both the business cycle and investors’ fears may be a better forecasting tool for the stock market. That’s my theory at least.
In practice, the copper-to-gold ratio seems to work fairly well. Here’s a chart of the ratio (in white) alongside the Dow (in blue).
As you can see, in late 2007, the copper-to-gold ratio made a lower high, then dropped sharply. I’ve drawn a white dotted line showing the lower high.
Meanwhile, the Dow was still making higher highs, which I’ve marked with an ascending blue dotted line. This disconnect is called negative divergence and it’s a great example of how weakness in the copper-to-gold ratio gave forewarning of weakness in stocks, which turned into the crash of 2008.
Fast-forward to this year… the same pattern may be unfolding.
Look to the far right edge of the chart above…
You’ll see the white copper-to-gold ratio recently turned down. I marked this lower high, relative to the high in early 2011, with a descending white dotted line.
Note: this pattern is still unfolding and it’s possible the copper-to-gold ratio will in fact turn higher soon and make new, higher highs.
But for now, we should be on guard for a declining copper-to-gold ratio.
If this ratio continues to drop, it could spell trouble for equity markets… just as it did in 2007.