The sky is falling again. Doomsayers are once again predicting major financial upheaval just as they did in 2013 with the fall of gold — only this time, it’s over the fall of copper.
Ever since hitting an all-time high of over $4.62 a pound back in early 2011, copper has been on a steady decline along with a host of other commodities. During this three-year tumble, the copper price twice stopped at $3.00 right to the penny, and both times rebounded upward.
But on March 11th, the unthinkable happened: copper fell through its multi-year major support line of $3. In just one week, from March 7th to the 14th, copper had fallen from $3.22 to $2.90, losing as much as $0.32, or 9.94%, to levels not seen since July of 2010.
The breach of copper’s long-term support raised concerns that global recovery is in peril, triggering massive sell-offs across all the major equity markets around the globe all week long — with Japan’s Nikkei index falling 6.4%, China’s Shanghai index falling 3.2%, Germany’s DAX falling 4.8%, the U.K.’s FTSE falling 3.5%, and America’s S&P 500 falling 2.1%.
The flight to bonds confirmed these sell-offs as a bona fide panic. The U.S. 10-year note’s yield slipped down by some 18 basis points from 2.82% to as low as 2.64%, close to a major support line in place for four months.
Even the long-hated precious metals got a lift, with gold rising some $37 or 2.8%. What’s significant about the gold move is that while copper was breeching downside support, gold breeched upside resistance of $1,350, climbing to $1,375 — a level not seen since last September.
But why all this fear and panic out of equities and into the safe-havens of bonds and precious metals? Is copper really so important that its fall should strike such terror in financial markets?
Well, it’s not really about copper, as the metal’s sell-off was itself a reaction to a different problem that runs deep within the financial system of the economic powerhouse that is — or perhaps was — China.
China Syndrome
The first reason behind last week’s copper and equity sell-offs, as well as the reactionary flight to the safety of bonds and precious metals, is a slew of disappointing manufacturing reports out of China over recent months, which lowered the nation’s growth forecasts. China’s economy is slowing, and it threatens to slow the global recovery with it.
In turn, a slowdown in manufacturing triggers a slowdown in expansion, which slows construction in everything from new factories to offices to housing. Since copper is one of the most widely used commodities in both manufacturing and construction, we can understand the downward pressure on the copper price over the past three years since 2011.
But recently something happened in China that broke copper’s back: a small Chinese solar company failed to make one interest payment on its loans.
That’s it? One company? One interest payment?
How does that collapse copper and equities around the world?
Though the event in and of itself is small, its implications are huge. It means the Chinese government will no longer step in to save an ailing corporation, but will instead allow it to fail. It marks a giant leap forward in China’s transition toward a free market society — slightly freer anyway. And it means the world can expect more Chinese company defaults in the future, especially given the slowdown of the nation’s economic activity.
Where the matter gets really serious for copper is that many Chinese corporations have been buying up copper and using it as collateral for their debt.
Why use copper for collateral?
Because the Chinese government has been planning ahead for the eventual recovery of the global economy and has been stockpiling copper for years in anticipation of the next boom cycle.
To encourage the import of copper, the Chinese government offered low-interest loans to corporations that would purchase copper from abroad and bring it into the country. Instead of the government buying so much copper itself, Chinese corporations would buy, import, and store the metal, ultimately using it as collateral for those low-interest government loans.
The program has been so popular that some 80% of all the copper imported into China over the past several years has been used as collateral for loans.
But if Chinese corporations are now allowed to default, and if a slowing Chinese economy makes such defaults more likely, there now exists the possibility of vast quantities of copper flooding the marketplace as banks liquidate the assets of failing companies, depressing copper prices in very quick order.
Yet there is a ray of hope for the copper market… none of that has happened. There hasn’t been an epidemic of Chinese corporate defaults, nor a flooding of copper into the marketplace. Even with poorer manufacturing reports out of China, the size of copper’s recent plunge on top of the steady declines since 2011 is not justified. There are other factors at play.
The Perfect Storm
Though the default of one Chinese company and the slowing Chinese economy would have a limited impact on copper prices, the turmoil we saw last week in the equity, bond, and precious metals markets is based on more than just the “potential” excess supply of copper — which hasn’t even occurred.
Adding to the copper worry is the escalation of tensions between Russia and the rest of the world over the deployment of Russian troops into Ukraine’s province of Crimea. A number of world leaders, including U.S. President Obama, are increasing their threats of sanctions against Russia, which range from denying entry visas to Russian business people to blocking bank transfers. Any increased risk of conflict always hurts equities and lifts the safe havens.
Then there is the extended length of the latest bull market, which has gone without a significant correction for nearly two years since the 10% correction of mid-2012. It reminds me of a John Wayne movie when he mentioned the cattle were so tense that a single gun shot in the night would be enough to trigger a stampede.
Add all of these factors together — slowing manufacturing in China, the default of a Chinese corporate loan, the potential release of vast quantities of copper into the marketplace, rising tensions in Crimea, and a stock market that is running hot without a break in years — and you get a highly tense herd of investors with their eyes wide open and their fingers on the sell button just itching to pull the trigger at a moment’s notice. All it takes now is that one shot.
Cooler Heads Will Prevail
If there is anything we should take away from last week’s global churning of the markets, it is that we must never put ourselves in a position of panic. Last week’s sell-off, like all other sell-offs, was panic driven. Since all those risks listed above still exist, the tension remains as well, which will likely result in more panic selling over the immediate and short terms.
But let’s stop for a moment and think of who the ones panicking are. They are investors who have become so complacent over the extended upward run of the markets that they have overextended their holdings to the point where they can’t endure even a small 2 or 3% pullback. Just imagine the devastation that a 2012-style 10% correction or a 2008-style 40% correction would have on them?
We should never reach so far that we can’t sustain such pullbacks. Especially now, since the cattle are so tense. 2014 will not be as smooth as 2009-13 has been — rather it will be a year of turbulence, and we must be prepared.
Yet we do not want to be out of the market either, since global economies are clearly much stronger than they were five years ago. We always want to be invested. But we should never use so much margin that we cannot support at least a 20-30% correction. And we should always have back-up funds available for those once-in-a-decade 40 to 50% routs.
What’s more, any pullback should be taken advantage of by buying value companies whose stocks have been beaten down to single-digit multiples, or at the very least buying sector ETFs for broader market exposure.
This applies to copper as well. Attempting to pick up copper at these multi-year lows is tempting but risky, for now that it has broken through its major support line of $3, there is no telling how far it will drop.
A better bet would be to go with a materials ETF, such as the Select Sector SPDR-Materials ETF (NYSE: XLB), which has outperformed a pure copper ETF such as the iPath DJ-UBS Copper TR Sub-Idx ETN (NYSE: JJC) — as noted in the graph below showing XLB rising while JJC falls.
Click Here to Enlarge
Source: BigCharts.com
Where JJC has gained only 45% over the past five years, XLB has nearly tripled it with a 127% return. The reason, of course, is that XLB is diversified across multiple commodity markets — including copper, iron, gold, silver, and others.
Another advantage is that where commodity funds like JJC invest in revenue-less commodities, material producer funds like XLB invest in mining companies that generate revenue.
Yet even when those diversified sector funds run into trouble — and they do — remember that cooler heads always prevail. It isn’t losing your shirt that causes you to lose your head; it’s losing your head that causes you to lose your shirt.
Now is not the time for excessive risk-taking. 2009 was the year for that. 2014 is the time for conservatism. Trim your margin exposure, book some of the profits you have gained, and keep some cash on hand to buy on the dips.
Come what may, always remember that the prepared investors always ends up buying what the unprepared investors were forced to sell — and at a discount to boot.
Until next time,
Joseph Cafariello for Wealth Daily
