Base Metals Correction: Start of a Crash or a Bear Trap?

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Includes: BDD, BDG, BOM, BOS, GLD, UDN, UUP
by: Kentpaul

So I have discussed the Ponzi-like nature of the Q4 2009 base metals rally in a couple of previous articles covering commercial trader positioning and the outlook in 2010.

Now that the year-end housekeeping by institutions that were playing catch-up having missed the rally has finished, it seems the new year has brought a number of negative surprises to the base metals bulls principally:

China has started to tighten. This is negative as the commodity/base metals bulls usually justify their stance with the view that ‘the Chinese will buy it’. Just as the Chinese speculators justify their physical hoarding of copper with the view that ‘the Chinese will buy it’.

The USD is rallying... against the Euro, at least. The greenback isn’t dead just yet and at least some of the commodity buyers had been using commodities as a proxy short-USD view.

What about the inventories?

Well, despite the pick-up in Q4 GDP numbers in the US and elsewhere and the possibility of a nascent inventory restocking cycle in the US, a demand rebound has not yet shown up in base metal inventory numbers at the LME warehouses.

LME Global Copper Inventories:

LME Global Copper Inventories

LME North American Copper Inventories:

LME North American Copper Inventories

In most cases the inventory situation for other base metals is even worse, for example aluminum:

LME Global Aluminum Inventories:

LME Global Aluminum Inventories

Looking at the CFTC data, commercial traders have built massive short positions in Copper over the last few months and the commercial longs have buckled this year, which has led the commercials to a significant net short position overall.

CFTC High-Grade Copper Commercial Trader Net Commitment:

CFTC High-Grade Copper Commercial Trader Net Commitment

So is this the start of a correction/crash or just a bear trap?

Despite having a bearish outlook for the medium term this year, I am willing to take a contrary view in the short term and stick my neck out with the call that the current sell off is just a sharp correction and a bear trap. The main reasons for this are that Greece's immediate problems will probably be dealt with soon, the USD is rallying due to perceptions of US economic strength (which is supportive of metals prices) and Q1 may see some follow through in terms of inventory restocking.

Additionally, China is just tapping on the brakes, and even if China does have a property bubble there is likely enough momentum for this not to come to the market's full attention for the next few months.

Finally, on a technical basis the base metals bulls are probably waiting for an excuse to pile back in.

As such I am willing to call that on the balance of probabilities the current correction is a bear trap. However, on the basis that I see something of a property bubble in China and an ongoing debt deflation in the ‘borrow and spend’ countries, which looks like it may trigger either a slowdown or a double dip later in the year, I would likely see any near term rally in base metals as setting up the market for a crash later in the year if and when the demand does not materialize.

Either way, 2010 looks set to be a volatile year.

Disclosure: no positions