Why Alcoa Stock IS Related To Aluminum Prices, Not Just The Stock Market

Jun.23.14 | About: Alcoa, Inc. (AA)

By Raul de Frutos

We received a comment to an article posted last week, studying the divergences that are happening between aluminum-related stocks and aluminum prices. The comment goes as follows:

"Alcoa is a stock, and stocks are 1% off all-time record-setting highs. Concerning the aluminum price, I beg to differ that it's showing signs of "life", take a look at these historical charts: http://bit.ly/vcetwj
The stock is in momo mode. Longs believe more stock gains are automatic. BMO Capital raised the shares to market perform, but their 2014 target is only $14, which is 50 cents lower than where it's trading. I'd say all info points to an overheated situation that needs to consolidate before healthier gains may be achieved in the future. Also, the short interest is only 5.7%, which is not nearly high enough to cause a short squeeze.
The fact that other aluminum stocks have rocketed also despite the commodity's sogginess (which you point out nicely) only underlines the fact that this is a general stock market phenomenon, and Alcoa is vulnerable at this price of
$14.50 for a near-term correction."

We would like to thank the writer for the comment, as it makes the reasoning process more dynamic and enjoyable and it's always good to hear from readers.

In this case, we disagree with this particular point of view. Here are our reasons:

First, we disagree that Alcoa stock is surging just because it is a stock. We would agree that stocks find it easier to move up on their respective indexes when the general stock market is healthy. However, this doesn't mean that the general market can make any stock surge. Indeed, the stocks of commodity-related companies are generally connected way more tightly to the underlying commodity than to the stock market indexes.

Copper Miners ETF (in green) versus Copper CME spot price (in orange) since 2011

Copper Miners ETF (in green) versus Copper CME spot price (in orange) since 2011

As an example, in the chart above we see how copper related stocks remain at low levels (moving with copper prices) despite the generally good performance of the stock market. The good performance of the stock market index is definitely not the only reason why Alcoa stock (and other aluminum stocks) almost doubled in price in only 9 months.

Second, we have studied the historical correlation between short interest - the quantity of stock shares that investors have sold short but not yet covered - and price movements and we haven't found significant correlation. Therefore, we don't even look at this variable as we have better tools to study the price action of a stock or commodity.

Third, we focus only on facts and don't listen to outside opinions. We don't know about BMO Capital predictions, but if they just raised their "target" it is because they were already wrong. Moreover, we don't believe in this type of "prediction" and certainly have never heard of a successful investor that trades on analysts' predictions. We also would argue that the stock is in momo mode, a stock moving just because of momentum without fundamental reasons. Stocks can go up or down for many reasons, not only for good earnings. In fact, stocks and commodities can remain overvalued or undervalued for long periods of time.

Finally, we remain neutral/bearish on aluminum as we were last year. Aluminum needs a catalyst to turn upward and that catalyst could be high expectations on the future use of aluminum in car and truck bodies.

Aluminum Spot Price on the LME since 2013

Aluminum Spot Price on the LME since 2013

Aluminum remains in a downtrend, but it is certainly showing some life as it is challenging its resistance levels. We don't attempt to forecast what the exact price will be in the next few months or years since we don't have a crystal ball (and no one does). Our goal is to read the market and provide buyers with the right time to buy/hedge their metal requirements. In the case of aluminum, as we have previously stated, buyers should start covering positions if prices near $2,000/ton.

Disclosure: No positions.