Speculation, Model Investor Behavior And A Call On Copper

Includes: CPER, CUPM, JJC
by: Dave Allen

Spec-u-la-tion (according to Google):

  1. The forming of a theory or conjecture without firm evidence
  2. Investment in stocks, property or other ventures in the hope of gain but with the risk of loss

As I was stuffing my face and watching the Seattle Seahawks blow out the Denver Broncos, I asked what the spread (betting line) for the game was. Somebody chuckled and said, "Denver was favored by 2 ½". It got me thinking about speculation. To set the betting line in Vegas, odds makers do a tremendous amount of research. They look at factors like injuries, weather and field conditions, speak to experts, look at matchups, and examine overall records and recent performances. They are trying to set a line that evens the amount of bets they take in, meaning that the bets the general public are making end up about even on both sides so that Vegas takes their handling charge and makes money either way. So, at kickoff, the odds makers and in part all bettors settled on an average outcome for the game of the Broncos winning by 2 ½ points. The Broncos ended up losing by 35 points.

All investing is speculation really. Take Amazon's (NASDAQ:AMZN) stock for example. It just reported disappointing results, based on earnings and revenue expectations, and the stock dropped 10%. What did this do to future expectations? The PE ratio is still over 600. A better example might be with investing in early stage biotech stocks. Some will take years before we even know if they have a drug that works and is safe enough to get approved. Regardless of how sound the investment philosophy or approach is, investors are speculating on a number of key factors and variables well into the future.

Human behavior drives speculation, and how investors react to certain circumstances and price trends is repeated over and over. Common behavioral traits include the herd mentality, being loss averse and holding onto poor performers, and having a bias toward thinking that present conditions will carry on indefinitely. This makes the need to model behavior as a factor all the more important for investors. Understanding price trends, and how investors have reacted consistently to similar price patterns and market environments historically can give you an edge in many investment functions including risk management, idea generation, trade timing and portfolio monitoring.

There are two views, in our world anyway, on modeling investor behavior. One is that investor psychology is investor psychology, whether you're talking about crude oil futures or Tiffany's (NYSE:TIF) stock. Other people feel that investors in a certain type of asset, like Energy Futures, have different expectations, timelines and goals that are driving their investing behavior than those investing in Consumer Cyclical stocks. There's not one answer here actually. The investors I speak with have sound reasoning that support both. Our research supports the fact that there is consistency to investor behavior to trends across asset classes, but modeling it within an investor's universe allows them to deploy their own expertise to enhance the statistics being presented.

To put this to the test, we decided to look at the current speculation in the Metals Commodities market, and found an interesting price trend in High Grade Copper. Copper hit a low of $3.15 on November 18th, then jumped 10% to $3.47 on December 27th, and has since dropped back down to $3.22 as of Friday's close. Without having a specific understanding of how investors feel or typically react to this type of price trend, we ran these examples through the EidoSearch tool to quantify it.

We looked at the last 3 months price pattern in the continuous futures contract for Copper (HG), and searched for all instances of this pattern in Copper's history to find the most similar matches and to see how investors reacted in the next one month. We then looked at the price trend, looking for the most similar instances in ALL Metals futures contracts historically. How have investors typically reacted to this price pattern, and have investors in Copper reacted in a similar fashion to investors in all Metals contracts?

  • We found 26 matches for the current 3 month price pattern looking at Copper's history, and in 65% of those cases, Copper was up in the next month an average of 5.49%
  • We found 52 matches looking at all Metals, and in 69% of those cases, the Metals contract was up in the next month an average of 3.48%

Please check out the charts below.

3 month price chart for High Grade Copper (HG):

(Source: EidoSearch Data as of 2/3/14)

Chart of the 26 highest correlated historical instances of this 3 month pattern in High Grade Copper, and the average return of those instances in the next 1 month of 5.49%:

(Source: EidoSearch Data as of 2/3/14)

Chart of the 52 highest correlated historical instances of this 3 month pattern in all Metals Contracts, and the average return of those instances in the next 1 month of 3.48%:

(Source: EidoSearch Data as of 2/3/14)

The reaction to this pattern historically is quite consistent, whether you're looking at the trading history in Copper alone or for all Metals contracts. Both point to a recovery in the price of High Grade Copper over the next month.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.