What do you get when you cross copper with gold?
Well, discount jewellery that will make your skin turn green, for one. But you also get a great indicator for the stock market.
It's called the copper/gold price ratio – and over the past several years, it has had a better than 90-per-cent correlation with the S&P 500.
But lately? Not so much. As stocks spent the summer going up, the copper/gold ratio was insisting that it should be going down.
The copper/gold ratio
The logic behind the copper/gold ratio as a market indicator is pretty straightforward. When economic growth expectations are high and perceived financial risks are low – ideal conditions for stocks – copper prices are typically strong due to growing demand, while gold prices are typically weak due to a reduced need for bullion as a risk haven. So the conditions that would typically send stocks higher are also the conditions that expand the ratio of the copper price relative to the gold price.
(The reverse conditions – a weak economy and heightened risks, which are distinctly negative for equities – hurt copper prices while elevating demand for gold, thus driving down the copper/gold ratio.)
But even the most healthy relationships go through rough patches, and this one took separate vacations this summer. While stocks rallied, the copper/gold ratio wallowed near recession-era levels. What could have caused the stock market and the copper/gold ratio to be in such glaring disagreement?
Two words: Central banks.
Infected with QE fever
While there were plenty of factors at work in the markets over the summer, there's no question that the underlying fundamental signals were muddled by the prospects for new stimulus initiatives from central bankers in the U.S., Europe and even China. Negative economic signals were routinely viewed as further arguments in favour of stimulus action – adding a positive spin.
At the same time, the notion of the central banks cranking up the money-printing presses undermined investor confidence in the U.S. dollar and euro – and sent them scurrying back to gold in its role as a solid currency alternative. The result? Central-bank talk gave stocks a reason to go up, while giving the copper/gold ratio a reason to go down.
With the stimulus plans now clearer, there's a good chance the relationship between the stock market and the copper-gold ratio will revert toward normal.
The general consensus among market experts is that the anticipated benefits of further quantitative easing from the U.S. Federal Reserve Board (announced this week) have pretty much already been baked into stock prices; with the QE news behind us, stocks will likely turn their attention to the tepid economy and slowing earnings. On the other hand, copper prices are rebounding after China indicated it plans to ramp up infrastructure projects to stimulate its economy.