Is a Crash in This Metal Signalling Stock Market Doom?

Posted by Alex Frey (@alexhfrey )

The US stock market keeps hitting new highs, but is a shiny metal warning that doom could lay ahead?

That is the argument some market pundits have been making lately.

Their calls are based on a recent collapse in the price of copper. Since February 24, copper has fallen 10% in 11 trading days -- a precipitous decline that seems incongruous when compared with what is happening in the US stock market.

This unusual price movement has gotten significant attention partly because the price of copper has developed a reputation as being an early warning indicator for turbulence in the stock market, and in the broader global economy.

In fact, many market observers are fond of calling the metal "Dr. Copper," since it is said to be better at making predictions than most PHD economists.

The theory goes that when companies start to anticipate lower demand, they start by placing lower orders of raw material, which hits the copper market first. These changes then take some time to cycle through the supply chain.

Copper Price

How Bad is the Current Copper Fall Relative to History?

To see just how unusual of an event a 10% eleven-day move in copper prices is, we ran an analysis using a history of copper prices derived from the futures market that goes back to the 1960s courtesy of the open financial data project.

We found that since July of 1959, copper has had 76 non-overlapping ten day periods where it fell by 10% or more in price. That is an average of slightly more than one such occurrence every year. So while the current episode may be alarming, it is certainly not historically unprecedented.

Many of these ten-day moves were much more violent than the current. The largest move happened way back in December of 1964, when the market fell 36% in the span of 11 trading days. In October of 2008 (a time that should be familiar to many as the "Lehman event"), copper fell 31%, or 3 times as much as the current move.

The chart below shows the number of times the copper market has fallen by at least the given amount over the past 54 years.


Are Dr. Copper's Predictions Actually Worth Anything?

To settle the issue of whether copper's title is well-deserved, we examined the one month stock market return (using the S&P 500 index) following the twenty most severe "copper market crashes" that were identified above. The table below shows the results. Rows highlighted in green represent copper market declines that were followed by a large increase in the stock market. Rows highlighted in red represent copper declines that were followed by a large decrease in the stock market. 

The 20 Largest 10-Day Copper Market Crashes Since 1960
Date Size of Copper Crash S&P 500 Return Over Next Month
12/31/1964 -36.2% 3.2%
10/10/2008 -31.4% 0.0%
2/2/1988 -28.2% 4.4%
3/13/1980 -23.5% -2.9%
10/16/1979 -23.3% 0.9%
6/13/2006 -22.9% 1.0%
4/4/1968 -22.6% 5.1%
8/23/1966 -22.3% -0.6%
5/28/1974 -21.0% -2.4%
9/23/2011 -20.7% 7.5%
6/27/1996 -19.1% -5.2%
9/9/1974 -18.7% -2.8%
6/25/1974 -18.5% -8.0%
5/28/2007 -18.4% 0.0%
4/28/1966 -18.3% -5.8%
2/13/1989 -18.3% 2.3%
4/30/1968 -18.3% 1.2%
11/19/2008 -18.3% 7.5%
12/18/2008 -17.2% -7.0%
8/3/1966 -16.5% -7.4%

The main observation that follows is that while the good copper doctor is very far from reliable, he does seem to pick something up. A copper crash was successful in foretelling fairly major stock market declines in June of 1996, June of 1974, April of 1966, December of 2008, and August of 1966. You wouldn't expect a random indicator to pick this many stock market falls of this magnitude.

But Dr. Copper also cried wolf (and caused anyone heeding his advice to miss out on a particularly good month in the stock market) in February of 1988, April of 1968, September of 2011 and November of 2008.

Broadening the analysis to look at each of the 76 "copper market crashes" identified in the 1960-2014 period, the stock market actually went up over the next month in 40 out of 76 occasions (53% of the time).

To hammer this point home: More than half the time after a copper market crash of equal or lesser severity then the one we have just experienced, the stock market has gone up over the next month.

Of course it could be that when it goes up, it is only by a small amount, and when it goes down, it crashes. To test this, we looked at the average return in the month following a copper market crash. We find that on average the stock market went up by .04% in the month following a copper market crash, or .45% in annualized terms.

While this is lower than the 6.6% average annual return (before dividends) the stock market experienced over the whole 1960-2014 period, it means that selling out of stocks every time the copper market crashes would not be a winning strategy in itself.

In other words, Dr. Copper may have this moments, but if he was a real surgeon, you would want to stay pretty far away from his operating table.

Should You Heed Copper's Call This Time Around?

The obvious answer based on the preceding would seem to be "no." But it should be noted that we can't rule out that the recent drop in the price of copper might be telling us something.

If you follow the S&P 500, the financial markets today may seem like sweetness and bliss. But beneath the surface, there could be a storm brewing, and copper might be an earlier indicator of that.

In particular, today the largest driver of the price of copper is Chinese demand. A fall in the price might be an early-warning of a "hard landing" in the Chinese economy, which would likely spread elsewhere.

So here, then, is our best advice on how to react to copper's fall: use it as a wake-up call.

Make sure that you have a plan in place that can take you through the next bear market intact, whenever it happens (you may want to consider following the dynamically-adjusted IvyVest Dynamic ETF Portfolio as one such option). If your strategy is built on as assumption of 20% stock market returns forever (or even 8% returns forever...), then use this as an excuse to pick a different strategy. But don't sell out of everything just yet.

"Dr. Copper" is far from perfect, but if he can stir us out of a false sense of complacency, then that's never a bad thing.

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By Alex Frey