Technical analysis of copper and stocks

April 24, 2016 09:00 AM

Individuals and scholars have looked for a way to predict the stock market since there was a market. Most often, this analysis involves mining mass quantities of data. As trading evolved, technicians developed statistical tools to measure data and create indicators. Traders began relying on broadly accepted statistical tools with their basis in academia. 

One tool used is intermarket analysis. This approach often involves looking at related markets. While that approach is sound, as are those broader statistical tools, here we will explore whether the answer to stock market trends could be found in copper, using a methodological twist. We’ll examine price patterns uncovered by traditional technical analysis. By using these technical analysis techniques, applied to various time frames, we hope solid conclusions come to light, key trends are identified and price predictions can be made.

Volatility shocks

Stock market volatility has long been an area of exposure that investors and firms have tried to reduce. Today’s financial markets are heavily integrated, and it is difficult to avoid the dramatic effects of a market downturn regardless of where your investments lie. 

In the week of Nov. 8, 2015, two Wall Street Journal articles highlighted the global rout in copper markets, discussing how large companies, such as Glencore, could face disaster if that rout persisted. The reasons copper had been shaken to its core, pundits said, stemmed from global supply outpacing demand, the U.S. dollar continuing to appreciate against various currencies and the dismal global economic outlook.

Copper is the most actively traded base metal and is a key material in various industrial applications. Because of this, it has always been viewed as an economic indicator. Copper has been referred to as the metal with a PhD in Economics. Despite the fact that many analysts believe that connection has broken down in recent years, we look at copper as a strong candidate for the independent variable in this study. 

Methodology

Here we use technical analysis as our primary tool, rather than more traditional statistical analysis tools such as regression analysis and cointegration. The goal is to uncover a forecasting tool for the stock market, so it makes sense to rely on measures that have been created for market analysis. Other types of statistical analysis, although quite useful, sometimes allow the analyst to get lost in the numbers.

We’ll review five-, 10- and 15-year charts of daily closing spot market prices for both copper and the S&P 500. These time frames represent an attempt to identify markers for the predominant short-, medium- and long-term trends. We will perform a full trend analysis to see if prices converge or diverge, whether one leads another, and whether they move with or against each other. The primary goal is to determine if the copper spot market begins to react before the stock market. Identifying trends such as these will help to solidify the relationship between copper prices and price fluctuations in the stock market. 

Data from both StockCharts.com and InfoMine were used in our study. Price patterns in copper and the S&P 500 were then examined for traditional technical analysis price patterns. This does, admittedly, introduce a level of discretion into the analysis. However, these methods represent how many traders analyze the markets; despite this popularity, they are often ignored in comparison studies such as this in favor of mathematical-based tools, such as moving averages or oscillators. For this study, we’re interested in the power of discretionary technical analysis to uncover links in related markets. While this review may not provide clean and clear mathematical relationships, we will see that certain trends and patterns strongly suggest that the copper spot market does indeed lead the S&P 500.

Technical connections

As we can see in the five-year chart, copper prices traded almost in line with the S&P 500 until the end of 2011 when copper and stocks began to converge (see “Leading the way,” below). Notably, from January 2010 to July 2012, a head-and-shoulders pattern occurs in copper.

In the beginning of 2013, copper prices continue to drop, while the S&P 500 is in a steady uptrend. About this time, the Federal Reserve Bank started sending signals that it would begin to ease off its quantitative easing. The dollar subsequently appreciated against various currencies, making copper priced in dollars more expensive for emerging economies. As currency-driven price increases muted demand, real copper prices fell, while the S&P 500 reached new highs. 

As of late 2015, the S&P 500 has broken its upward trend. U.S.-based multinational companies have some exposure to global growth outlooks as they do not solely receive their revenues from within 
U.S. borders. Copper, a global commodity, is showing its strength as a key indicator. The strong dollar is making copper more expensive while emerging economies’ demand for the metal is diminishing. Based on the technical analysis, a correction in the S&P 500 was expected. In addition, it’s worth noting that in the context of a four-year downtrend in copper, spot prices have resistance at $2.75 per pound. If copper were to break through that level, prices should rally over a period.

Longer perspective

The 10-year chart offers more data to help analyze key trends (see “Broader view,” below).  An extra five years of historical data gives us more insight into the connections between copper and the stock market. Indeed, we can see that the copper market moved somewhat in tandem with the S&P 500 from 2005 through 2012.

Most notably, the double top pattern, finding resistance at $4 per pound, formed. Shortly after, the stock market collapsed, ushering in the 2008 financial crisis. Roughly three years after the market downturn in 2008, the copper market rebounded to $4.50 per pound, penetrating the earlier resistance level. Then, the head-and-shoulders pattern provided too much resistance to overcome. 

In searching for a fundamental reason for why copper broke through the resistance level of $4 per pound on this second attempt, a BBC News report cites the metal’s all-time high was tied to strong global economic recovery and that most countries held low stockpiles as demand outpaced supply. Less than a year after reaching its all-time high, copper prices began to tumble. CNNMoney cited that copper prices decreased because of sluggish global growth, the worsening European debt crisis, the Federal Reserve’s dismal outlook and indications of slowing manufacturing activity in both China and the Eurozone.

The 15-year chart provides yet again another five years’ of historical data (see “Shifting signs,” below). This chart is the most interesting of the three. We can see that in mid-2000 through early 2004, there is a downward channel for the S&P 500; once the trend was broken, it led copper prices higher. Between April 2004 and toward the end of 2004, an ascending triangle was present in the copper market; this is a notably strong bullish indicator. Subsequently, copper prices skyrocketed from $1.50 to $3.50 per pound over the next two years. In the same time frame, the S&P 500 jumped roughly 400 points to 1,600 from 1,200.

Also note the rising wedges in both markets. Clearly, the pattern for copper leads that for the S&P 500. A rising wedge is a strong bearish indicator in which two trendlines are converging in an upward direction. Shortly after copper hit the lower trendline indicating a reversal in its upward trend, from 2011 onward, prices have fallen, further supporting the analysis conducted for the five-year chart.

Based on the full 15-year scope, it is apparent that the S&P 500 has a rising wedge as well. If it breaks the lower trendline, then we will likely see the S&P 500 follow the same pattern we saw in 2011 with copper prices. This offers support to the analysis conducted on the 10-year chart. This also would further strengthen the study of the copper spot market leading the stock market. Conversely, if the S&P 500 breaks the upper trendline, then we will see the continuation of the current pattern. 

New angles

As we can see, copper prices do, in many cases, lead the stock market. Technical analysis is a fresh approach to explore this connection. Interestingly, we saw that the copper market doesn’t always lead stocks. Indeed, the S&P 500 led the copper prices based on a downward channel pattern from 2000 through 2003. Shortly after this occurrence, a rising triangle was identified in the copper spot market. The stock market gained roughly 400 points during the next two years, a 33% increase.

While there is sufficient evidence to support that the copper market often leads the S&P 500, some bases remain uncovered. A continuation of this study might involve charting historical copper spot prices against the strength of the U.S. dollar, the Dow Jones Industrial Average, other major stock indexes, 
as well as trading volumes between copper and the other variables being analyzed. Furthermore, a larger data set will help to identify more trends to expand the validity and reliability of the study.

While this approach may lack the precision that quants and systematic traders demand in their signal triggers, it shows that discretionary practitioners of traditional technical analysis may be able to find an edge in stock market forecasting if they apply their tools to copper.

Many will view the recent breakdown in correlation to stocks as proof this is not a valid approach, but this could be the exception that proves the rule, especially when we consider outside influences like the massive quantitative easing from the Fed. If history is a teacher, then that correlation may return now that the Fed is determined to normalize.

Note: Copper led the S&P  500 from 2011. Our market was slow to reach due to QE from the Fed and low interest rates. 

About the Author

Anthony Mirafiore is a market technician studying for his MBA in Finance at the University of Bridgeport.