Predicting Copper & the Importance of the Gold/Copper Ratio

I want to continue with the copper theme here, but let’s briefly recap where we have been over the last few days. We originally suggested a way of forecasting oil movements and prices, with Kevin Klombies’s copper/oil ratio playing the primary role. Based on this and techniques I have developed, we came to the tentative conclusion that oil would hit $150 within the next 15 months, and that this oil spike would bring a massive stock market rally to a conclusion and then provoke a resurgence in gold (which we predicted would soften until some time around the 2012 US elections).

Considering the decisive role of oil in the world economy, finding a way to predict oil would be key to understanding the underlying drivers of market movements. The volatility of oil also opens the possibility of impressive profits for those who can time it. In any case, a burst in oil prices has been almost always preceded by a surge of copper prices, and so the question is, if copper drives oil in some fashion, what drives copper?

We then showed that the copper price largely mirrors the dollar index/10-year yield ratio (that is, they have an inverse correlation), but then we also observed that the oil/copper ratio appeared to be predicting the dollar/yield ratio, which effectively means that the copper/oil ratio leads the copper price. In a way that is not surprising; after all, after a debilitating oil spike—and they are all debilitating—this results in a sudden collapse in oil prices which then opens the way to economic recovery (with no small help from a generous monetary regime), which is bullish for things like industrial metals such as copper.

In short, the copper/oil ratio is another market oracle, perhaps not as profound as the oil/gold ratio we have made the center of our market system, but profound nonetheless. The copper/oil ratio, to restate our case, can be used to forecast oil, copper, and the dollar/yield ratio.

As a brief aside, we have been arguing that the copper price mirrors the dollar/yields, and Klombies has demonstrated a very tight negative correlation between copper plus crude tripled (i.e., copper + (3 x crude)) and the dollar plus bonds (effectively the same as the dollar/yield ratio) over the course of the last 12 months. I am going to call this combination of commodities the Klombies Industrial Commodities Index (KICI) for short. It is a nice, clean, simple way of estimating industrial commodities, and I suspect that this combination of oil and copper is a better fit with the dollar/yield ratio than copper alone, so as always, one should take heed of what Mr Klombies says, but my purpose for the time being is to distinguish copper and oil.

Yesterday, I said that I preferred to move the copper argument laterally before trying to plunge into some of the deeper issues that I believe are driving our inherently imbalanced economic system, so let’s do that by looking at a few more P&F charts. In the essay I submitted to Libertarian Papers, I suggested that the copper/gold ratio is effectively equivalent to the copper/silver ratio. I also suggested that the oil/gold ratio is equivalent to the oil/silver ratio. There is probably a good way to incorporate the oil/silver ratio into our oil analysis, but we will leave that to another day. Let’s stick with copper for the moment.

copper/gold ratio

copper/silver ratio

These two charts which compare copper versus gold and silver since 2000 are remarkably consistent with each other. If there is any suggestion of a breakdown in this correlation, it might be in the action of these two ratios since the market (using our as yet unmonikered system) went into ‘equity phase’. This may mean that the correlation between the copper/gold and copper/silver ratios only holds true under the conditions of the ‘gold phase’ and ‘oil phase’, or it may be that the markets just need some time to sort themselves out. At some point, we will have to get into the question of silver, but not today.

Sticking with copper, let’s see how these ratios relate to the price of copper, if at all.

copper

One might wish to keep the copper/oil ratio in mind, as well.

copper/oil ratio

The copper/gold ratio seems to have a tighter correlation with the price of copper than does the copper/silver ratio. This probably has something to do with the similarities between copper and silver (at least, from a technical standpoint), as well as the market phase we entered last year. In any case, copper has been hitting new highs this year, but relative to silver, it has been hitting new lows.

In general, however, we see that copper began moving up in late 2003 and this move was confirmed by it’s strength relative to gold, silver, and oil. Oil’s move up in the second and third quarters of 2004, however, appeared to put a temporary check on copper, which traded sideways in dollar-denominated terms and in terms of gold. It continued to work its way up against silver, although this appears to be a consequence of silver’s own weakness (and again, it’s similarity to copper) in the face of strong oil.

Once the impact of oil subsided, copper resumed its upward movement, except relative to oil itself. The copper/oil ratio didn’t begin to move up convincingly until late 2005. By mid-2006, the copper/oil ratio had crossed the 5:1 mark and was topping out in terms of silver and gold. Although in May 2007 (versus oil) and May 2008 (in dollar terms), copper achieved new highs, mid-2006 was the high water mark for copper.

Copper versus precious metals, especially gold, seemed to be a fairly good predictor of coppers upward movement, and more decisive than the copper/oil ratio. On the other hand, by the time of financial crisis, copper/oil managed to bottom before copper/gold, although copper/oil again appeared to lack decisiveness moving forward.

For the most part, at the moment, although copper/gold and copper/oil look to be under pressure and are not sending clear signals, they seem to be hinting at copper strength.

But, we seem to be drawn back to the conundrum we faced yesterday wherein the copper/oil ratio appeared to be the motor behind both copper and oil prices and the oil/copper ratio seemed to be a lead indicator of what the dollar/yield ratio would do (which is closely although inversely tied to copper and industrial commodities generally). The difference is, however, that now the gold/copper ratio seems to do an even better job of predicting the dollar/yield ratio than the oil/copper ratio appeared to do.

Here is the dollar/yield ratio compared to the gold/copper ratio going back to 2000.

gold/copper ratio

And oil/copper for good measure.

oil/copper ratio

I think it is extraordinarily clear that the gold/copper ratio has a much tighter fit with the dollar/yield ratio than the oil/copper ratio had. The oil/copper ratio, if you recall, had notably failed to predict the 2010 bump upwards in the dollar/yield ratio, which we attributed to the special nature of the rise in oil from 2009 until early 2010. I suspect that there is still something to that notion, but the gold/copper ratio does manage to ‘predict’ the dollar/yield’s 2010 move.

So, everything that we argued yesterday still applies, but it seems that our advocacy of the oil/copper ratio should now give way to the gold/copper ratio to predict the dollar/yield ratio and, by extension, the copper/gold ratio to predict industrial commodities—in this series of reflections, copper.

Just to mix things up, here is a precious metals index/copper ratio.

Precious metals/copper ratio

You will see that it mirrors the dollar/yield ratio almost perfectly, even in terms of time. It suggests, I think, that copper is showing faint flickers of life again relative to precious metals and that this should bring the dollar/yield ratio down, which is bullish for commodities such as copper (and the KICI).

Before wrapping this sprawling discussion up, it is worth noting that the gold/copper ratio is able to predict in advance what the precious metal/copper ratio is only able to mirror. And, although the oil/copper ratio is somewhat erratic and difficult to gauge, we should not ignore its importance.

In conclusion, our ‘lateral move’ in our attack on the copper question today has produced some useful results and opened up a number of routes for investigation, but this is simply another way of saying that we have even more questions than answers now. The relationship between copper and precious metals, most especially gold, now would seem to supersede, although not completely eliminate, our dependance on the oil/copper ratio.

It might be better to start reflecting on the total complex of industrial commodities rather than focusing on copper alone. But, before I do that, I would like to consider the relationship of the oil/gold and oil/silver ratios we mentioned above and to see if something useful might be harvested from that. A fuller consideration of precious metals, especially silver, also awaits. And, we still seem to be dancing around the central issue of interest rates. Our hypothesis is that central banking’s raison d’etre is to make war on Gibson’s paradox and it is the market’s violent reaction to this that creates these massive and unnatural moves in currency, commodity, equity, and bond markets. On the other hand, extreme though these reactions may be, they occur along fairly predictable lines.

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