Metals Market Correlations

Scott Wright     March 31, 2006     3240 Words


As todayís commodities bull market has shown in recent years, it plays host to many different playing fields.  In any bull market, secular upward trends are readily apparent from the outside.  But a long-term bullís strategic nature houses a myriad of tactical trends in which various sector strengths and weaknesses define its character.


As an example, in the 1990s when the tech bubble was rapidly expanding, various sectors found strength and weakness within different stages of the bull market.  Software, hardware, telecom, dot-coms, ISPs, tech consulting and biotech all enjoyed glorious runs within the overall secular bull market.  But some of these sectors found their strength at different times than others.  Some lagged, some led and some built momentum and strength for others to follow.


Well the 21st century commodities bull has a similar flavor.  Gold has been the stalwart of the group since the beginning of the bull and has consistently risen paving the way for its volatile sibling silver.  Energy decided to jump in shortly thereafter with oil and gas leading the way among many other energy plays.  Base metals are now starting to draw attention and appear to be the next sector of commodities to ride the bull.


Base metals have seen fantastic gains for the better part of two years now, but only in recent months has the footprint of their coverage expanded among the greater investment community.  As the prices of these commodities rise sharply in the open markets, the producers and explorers that bring them to market are starting to capture the interest of investors and speculators everywhere.


Many financial-market analysts and commentators have given attention to base metals lately because of the recent bull-to-date and all-time highs being achieved.  But for stock investors it is the stocks of the companies that produce these metals where the real excitement has been.  These highs directly spill over into the financial performance of the companies that bring the copper, zinc, nickel, aluminum and lead to market in turn positively affecting their stock prices.


At Zeal we also see the writing on the wall and embrace the incredible opportunities that exist in this sector.  As gold is consolidating and brewing its next upleg, we have focused much of our attention lately on the base metals front in order to flesh out these opportunities.


Now in order to build a foundational understanding of this base metals bull market it is imperative to understand its drivers.  Iím not going to dig too deep into the fundamentals right now, but simply put, we are in the midst of major economic imbalances for these commodities.  For several years now demand has outstripped supply for these metals and global warehoused stocks have been falling to alarming lows in order to feed the appetite of the global economy.  Economics, as it should be, is the major driver of this recent bull run.


My partner Adam Hamilton and I have written various commentaries in recent months discussing the fundamental and technical aspects of this sector in detail.  By doing this not only are we educating ourselves on this base metals surge but we are dutifully searching for investment and speculation opportunities in this realm that will allow us to multiply our capital.  In order to exploit this base metals trend it is important to understand where it falls in the grand scheme of the secular commodities bull.


Recently there has been a consolidation on the overall commodities front.  Believe it or not this consolidation, and perhaps even a correction, is necessary and needed in order to maintain the integrity of the secular uptrend.  Though the recent struggles on the commodities front have ultimately been minor, especially since the metals have swung to approach their tops once again, they can sure create a stirring excitement among the talking heads of the mainstream financial media.


All it takes is a couple consecutive down days to supply ammunition for the mainstream influential to proselytize the end of the commodities bull.  Frankly I think this is silly as evidence suggests we are still in the first third of what people will look back on as the greatest commodities bull in history.  The purpose of this essay though is not to sell you my fundamental reasoning for this, but to take a closer look at some of the concerns that have cropped up around the base metals sector of recent.


As stock investors and speculators, our fulfillment and satisfaction is obtained through picking the winners among the various commodities explorers and producers.  Because of the recent popularity of base metals stocks, many are starting to lump them in and categorize them in the same group as the market-darling precious metals stocks.


As mentioned above and proven throughout history, different sectors within a secular upward trend ignite at different times.  Base metals have ignited, and are indeed starting to enjoy gains like those weíve seen with the precious metals.  But how closely are they correlated?  Now that investors and speculators have caught wind of the opportunities that exist with base metals stocks, is it fair to lump them in the same group as precious metals stocks and are we to expect them to ride the same wave going forward? 


Many times in the past we have attempted to answer questions like these through some good old-fashioned correlation analysis.  First we looked at gold stocks and their relationship with gold.  The whole concept of leverage is tightly defined in this relationship and we have been able to successfully trade gold stocks with what weíve learned from these studies.


Then as energy stocks made their run to popularity, we took a closer look at how the stocks of the companies that produce energy relate to not only their underlying commodities, but also to the performance of the general stock markets.  Adam penned a number of essays in this regard that revealed fascinating results that currently help us trade the energy cycles.


Now as we learn how to trade base metals stocks, letís take a look and see how these stocks relate to the general stock market, gold, gold stocks and most importantly their underlying commodities.  Copper has been the most popular base metal thus far from a stock trading perspective.  Copper recently hit another all-time high giving it a 313% bull to date gain and the companies that are producing this metal are starting to realize enormous profits as they struggle to supply the worldís fast-growing demand.



Our first chart above shows copperís and goldís performance thus far in the secular bull market.  Up until 2003 the bull market for metals primarily consisted of precious metals.  As is the case for copper and most other base metals, it decided to join the party a couple years after gold took the lead.  By the end of 2003 the metals sector of the bull market changed its tune from a precious metals bull to a metals bull.


A major concern Iíve been hearing from people is now that base metals have joined the commodities parade, is that there will now be parity between copper stocks and gold stocks, or any base metal stocks and gold stocks.  At first look the chart above can certainly visually support this in looking at the relationship of their underlying metals.


To see if this is true and how it relates to the stocks of the companies that produce these metals, correlation analysis might be a good start in order to test these driversí effects on the stocksí tactical price movements.  Statistical correlations between two sets of data can often give us direction and help explain price movements.


The chart above analyzes the correlation between gold and copper.  Next to the correlation numbers above are the associated r-square percentages.  This percentage reveals how likely the daily movements of copper can be statistically explained and predicted by movements in gold, which is the more important number as far as speculators are concerned.


The pictorial illustration given above is what many people have been chatting about.  Correlation analysis can be sliced and diced any way you like, but these visual trends give us a pretty good idea of our parameters.  Since the beginning of the commodities bull market in 2001 copper and gold have had a correlation of 0.921 which yields an r-square of 85%.  This correlation is by far the highest to gold compared to all the other base metals, but I wanted to use copper not only to show a conservative demonstration but because of its growing popularity.


It is easy to see in this chart where copper started to take off.  From 2001 to 2002, copper and gold had a correlation of -0.236 with an r-square of 6%.  During this time there was virtually no correlation between the two metals as gold was on the rise and copper was trading flat.  But in 2003 copper finally picked up steam and adopted a bull run of its own with much more semblance to gold.  In the last three years copper and gold have had a correlation of 0.948 with an r-square of 90%.


While copper has an initially impressive correlation with gold, the other four primary base metals we track which are zinc, lead, nickel and aluminum average a bull-to-date correlation with gold of 0.867 which yields an average r-square of 75%.  So 75% of the daily behavior of these metals in this bull market could be explained or predicted by gold on a strategic level.  But because of the erratic behavior of these metals their post-2003 r-square is only 72%, not nearly as impressive as copper.


And to zoom in a little further, all five of these base metals including copper have an average correlation to gold so far in 2006 of only 0.617, with an r-square of 38%.  So even though the strategic trends have higher correlations, the tactical performances of the metals in 2006 still show independence.


Though base metals do exhibit mildly impressive correlations with gold, I suspect a majority of this relationship stems from the strategic nature of the overall metals bull market and not necessarily a direct gold relationship.  Each commodity is ultimately driven by its own fundamentals, and even though psychological momentum factors can create some initial similarity, economics always rule.  My reasoning for this becomes clearer when you take a look at the actual stock comparisons.


To take this analysis to the next level itís worth a look at actual stock comparisons.  Using copper as an example again, the chart below provides correlation and r-square numbers for copper stocks to copper and copper stocks to gold stocks.  For copper stocks I used conservative stock data from the two largest primary copper producers in the world that are traded on the U.S. stock exchanges.  And for gold stocks I used the venerable HUI gold-stock index that is comprised of some of the biggest and best global gold producers that tend to have the highest leverage to the underlying metal they mine.



After looking at this chart, the herding-metals-stocks theory may not have as firm a ground to stand on as thought.  Gold stocks, represented by the HUI, have throughout this bull market had an excellent correlation to the underlying metal they produce.  Bull to date gold and the HUI have had a correlation of 0.964 with an r-square of 93%.  But the copper majors listed above have had a correlation to the HUI of only 0.855, an r-square of 73%.


So even with copperís and goldís initially impressive r-square of 90% during this same period of time, the stocks are showing their loyalty.  These copper majors sport a correlation to copper of 0.968 yielding an r-square of 94%.  So the daily activity of these copper stocks can be explained or predicted to an accuracy of 94% based on what the price of their underlying metal does.  According to this analysis, copper stocks are much more likely to follow copper than gold or gold stocks.  As it should be, copper stocks move with copper.


And this is the case for more than just copper.  Two of our favorite zinc stocks, two successful Canadian companies that happen to rank as two of the top global primary zinc producers in the world, have bull-to-date r-square values over 90% in correlation to zinc metal prices.  And this is the case while zinc and gold have had a bull-to-date correlation of only 0.826 with an r-square of 68%.  As it should be, zinc stocks follow zinc.


And nickel is even more obscure.  This commodities bull to date has had a nickel and gold correlation of 0.867 with an r-square of 75%.  Yet since 2003 when the metal started showing volatility gold and nickel have only had a correlation of 0.620 with an r-square of 39%.  In the last few years nickel and gold have had virtually no correlation.  Yet the stock of the second largest producer of nickel in the world has an r-square of 86% to nickel.  As it should be, this nickel stock follows nickel.


Uranium is another mineral we have been following as well.  Though this metal is more of an energy play than a base metal play, it has exhibited some of these same characteristics.  The stock for the top uranium producer in the world has an astonishing correlation to its underlying metal of 0.979 yielding an r-square of 96%.  So this stockís movement can be explained or predicted with 96% accuracy based on the movement of uranium.


As mentioned earlier, since we are in a metals bull market within the greater commodities bull, most of these metals will have noticeable correlations between themselves.  Not only is this due to the close-knit timing of their economic imbalances, but also because of the strategic nature of their operations.  The companies that mine these metals, whether it be gold or zinc, have much of the same constraints and limitations in bringing their metals to market.


If there is an economic imbalance, as there is in virtually all metals now, it takes hefty amounts of time and capital for these producers to discover, develop and produce mining output.  Mixed with the fact that easy resources and discoveries are less common today, only does an environment of rising prices make sense.  But even with these similarities, ultimately it is the fundamentals of each individual metal that will continue to drive its bull.


Base metals each have various industrial uses, but global economic expansion is what has and will drive the group as a whole.  As global infrastructure is upgraded and expanded the demand for these metals continues to rise.  Bull to date while gold and silver have risen 128% and 187% respectively, base metals have seen even higher gains.  Aluminum has gains similar to that of gold and silver, but copper, zinc, lead and nickel all have bull-to-date gains well over 250%.  And as this next chart shows, base metals stocks have reflected their underlying metalsí gains by more than rivaling the performance of gold stocks in the last few years.



Since there are not any effective base metals stock indexes that I know of, I decided to create my own using a simple price-weighted method.  This just-for-this-essay index is comprised of ten of the biggest and best base metals producers traded in the financial markets that produce a fair sampling of each of the major base metals.  I simply added their daily adjusted closing prices in which the sum revealed our makeshift index.  Though Iím not a big fan of price-weighted indexes, it seemed easiest for this example.


As you can see visually, base metals producers have enjoyed a fantastic last three years.  As the prices of the metals they mine have rocketed skywards, the companies leveraged to benefit from these gains have been greatly rewarded.  Since 2003 this sampling of major base metals stocks has risen an average of 277%.  To put these gains in perspective, the HUI gold-stock index has risen only 201% in this same period of time.  And since 2004 this composite base metals stock index has climbed 151% while the HUI has gone up only 107%.  Though gold stocks are certainly nothing to turn your head at, base metals stocks have had greater than 40% better gains on average than gold stocks in this stretch of time.


And the most astonishing thing about this comparison is the fact that the combined market capitalization of the ten stocks in my base metals stock index is nearly five times greater than that of the fifteen stocks in the HUI!  Usually stocks with larger market caps do not move as fast as those with smaller market caps in a bull market.  Imagine the past and future gains of smaller more obscure base metals explorers and producers when investor capital really starts to take part in this base metals bull.


These base metals stocks have tended to follow the trend of their underlying commodities rather than that of gold stocks or gold.  As you can see in this chart since 2003, this base metals stock index and the HUI have had a correlation of 0.839 yielding an r-square of 70%.  So even though they visually look like they are following the same trend, outside of the overall metals bull the x-factor of actually reacting to the price movements of their underlying commodities seems to be the main driver of their volatility.  And base metals stocks certainly donít correlate well with the general stock markets either.  In the commodities bull to date they have had a correlation of 0.586 with an r-square of 34%, figures hardly worthy of betting your buck on.


In actuality, base metals prices should have nothing to do with precious metals prices.  Their core fundamentals have little commonality.  Though precious metals have various industrial uses, these are not their primary drivers.  Base metals are essential industrial minerals and are driven by pure economic and industrial forces.  Precious metals, more specifically gold, are still slave to the economic forces of supply and demand as are base metals, but they have a much more complex nature to their demand as currency and store-of-value factors come into play.


Base metals prices will continue to rise until supply and demand come into balance.  And the companies that explore, develop and produce these metals will reward investors and speculators with legendary gains throughout this bull market.  Because of the nature of the mining business in addition to the fact that our world continues to consume at a record pace, it will likely take many years for this to happen.


At Zeal we have been identifying base metals producers and explorers that are in position or are positioning themselves to greatly benefit from the bull market in their underlying commodities.  In our newsletter we currently have several base metals companies on our Watch List and have triggered buy recommendations on several of these stocks to our subscribers in recent months.  If you would like cutting-edge analysis and stock picks on todayís commodities bull, please subscribe today.


The bottom line is even though a metals bull market is underway, the core fundamentals of each individual metal are what drives its price and the stock prices of the companies that bring it to market.  A greater commodities bull market does have influence on the strategic trend of base metals stocks, but ultimately they ride the wake of the metals they produce, not the stock market, not gold, not gold stocks.


Scott Wright     March 31, 2006     Subscribe