Precious Metals and Industrial Metals Are Correlated
Although gold is considered to be a precious metal and copper is strictly an industrial metal, the two markets show a surprisingly strong correlation on the long-term timeframe. Over the last three decades, these two markets have generally trended in the same direction. Fundamentally, this could be due to the fact that inflation and global economic growth influence both markets.
The Gold/Copper Spread
Since the 2011 peak in commodity prices, both copper and gold have been in multi-year bear markets. Copper has taken the bigger hit as China, the world’s largest consumer of copper, is experiencing the slowest economic growth in decades. The recent stock market meltdown accelerated the move to the downside and smashed the copper/gold spread to historically low levels.
At yesterday’s close, the value of two December copper contracts was worth nearly $3,000 less than the value of one December gold contract. Over the last thirty years, there have been less than half a dozen times when two copper contracts were valued at a discount to the value of one gold contract. Normally, a pair of copper contracts should have a premium of $15-20k or more over a single gold contact. This indicates that a buying opportunity could be shaping up.
The Gold/Copper Ratio
To normalize the relationship between these two metals, take a look at the ratio. The ratio between the value of a December gold contract and a December copper contract reached 2.05:1 yesterday, which is just below the January peak of 2.10:1. A reversal from here could establish a double top on the daily timeframe.
More importantly, history shows that a ratio of 2:1 or higher is a rare event and one that is unsustainable. On the monthly timeframe, we can see that the ratio hit nearly 3:1 back in 1987. Since then, however, there have only been a half-dozen times when the ratio made it up to 2:1 and the 2009 peak of 2.53:1 was the only time when it was significantly surpassed. Even then, it only lasted a few months before the ratio reversed and crashed back to earth. The takeaway from this is that a ratio of 2:1 or higher indicates that a major reversal is at hand. We are there now.
The Current Technical Pattern
The December copper(x2)/gold spread has been in a multi-month decline off the May 1st top. It is closing in on the January multi-year low where it has the potential to establish a double bottom or even trigger a Wash & Rinse buy signal.
The spread has closed below the declining 50-day Moving Average every single day for nearly a quarter of a year. The 50-day MA has been an accurate trend indicator since Thanksgiving. A two-day close below the 50-day MA in late November led to a $34k drop into the late January low. A two-day close back above the 50-day MA in late February (for the first time in three months) saw follow-through of an additional $17k into the May Day top. The two-day close back under the 50-day MA in late May (for the first time in three months) has pushed the December copper(x2)/gold spread another $19k lower so far. Therefore, a two-day close back above the 50-day MA for the first time in at least three months may be our cue to climb aboard the long side of the trade.
The blog will make a hypothetical trade to buy two December copper contracts and simultaneously sell one December gold contract if the spread between the value of the sum of two 25,000 lb. copper contracts and the value of one 100 oz. gold contract makes a two-day close above the declining 50-day Moving Average. Initially, the spread should be liquidated on a two-consecutive day close below the contract low that precedes the entry.