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In the summer of 2011, I laid out the case for anticipating a crash in commodities and defined some rules to determine when to start buying commodity-related stocks (see "Profiting from Physical Assets in a Resource-Constrained World - Rules and Picks"). The current crash in iron ore prices has made me realize that an update to this playbook is long overdue. As a prelude to such an update, I am demonstrating how well last year's playbook has worked for Freeport-McMoRan Copper & Gold Inc. (FCX) (so far).

One of the rules from the playbook states:

QE2 (the second round of quantitative easing) will be used as a benchmark for measuring any correction in commodities. An erasure of most or all gains from late August, 2010 will be considered a major buying signal. I will be flagging individual plays when (IF) this target gets hit.

From this rule, I defined the "QE2 reference price" as the price of a commodity or commodity-related stock at the time of Ben Bernanke's Jackson Hole speech August 27, 2010 where Bernanke essentially signaled the coming of QE2. Given some stocks did not immediately respond to the signal, I loosely defined the price as "late August." For precision going forward, I will define the QE2 price as the closing price on August 26th, the day before the QE2-signaling Jackson Hole speech. The weekly chart below shows how FCX surrendered all its QE2-inspired gains in September, 2011 and how in 2012 this reference price has provided solid support for the stock.

(click to enlarge)

The QE2 reference price has served as a strong trading guide for FCX

The first thing to note is that, as expected last year, commodity-related stocks like FCX eventually gave up all their QE2-inspired gains. What did NOT happen as expected was a crash in China that caused commodity demand to implode. So buying at the QE2 reference price has become a relatively consistent winner across a range of commodity-related stocks. In fact, I was pleasantly surprised how this one rule was sufficient for executing trades and for keeping calm during sell-offs.

The daily chart provides a close-up of the trading action in FCX featuring the QE2 reference price support.

(click to enlarge)

FCX bounces off the QE2 price and confirms bullish move with surge above its 200-day moving average

Source for charts: FreeStockCharts.com

Note how the QE2 price provided support for FCX all summer. Friday, September 7th's surge has essentially confirmed that bottom with a 8.5% rally mostly above the critical 200-day moving average (DMA). I believe the strong surge was caused by the double whammy of a poor U.S. jobs report that seemed to confirm for the market that QE3 is coming, and the announcement that China's National Development and Reform Commission "…approved big-ticket infrastructure spending projects, taking in ports and hundreds of miles of underground railways."

I have made the case this year that the Federal Reserve is biased for further monetary easing, and I reiterated this case in "Monetary Easing, The Counterfactual, And A Lower Dollar in the Balance." The case for more stimulus from China is more murky. In "China gloom to end our mining boom?," the Sydney Morning Herald quoted several Chinese officials and economists who appear to throw cold water on the idea that the NDRC's proposal will get implemented. Moreover, Chinese President Hu Jintao has claimed that he wants to use the slowdown in China's growth to promote a more balanced economy. I can only assume that if the proposal gets rejected, commodity-related stocks like FCX will sell-off almost as rapidly as they rallied last Friday. However, such a sell-off will provide a fresh buying opportunity to build a position.

In future posts, I will describe the new commodity crash playbook and some revised rules for entry and exit.

Be careful out there!

Source: Using The QE2 Reference Price To Buy Freeport-McMoRan