Dr. Copper May Be Telling Us To Watch Out Below

 |  Includes: BHP, FCX, RIO, SCCO, XSRAF
by: David White

Many commodity gurus insist that Dr. Copper (the copper price chart) is the best indicator for which way the economy will go in the near future. If that is true, the US equities market is likely in for a big downswing soon. The two year chart of copper below shows it is likely preparing for a big move upward or downward.

(click to enlarge)Click to enlarge

The two lines I have drawn in show copper has been forming a long term pennant formation. This means that copper is building up energy for a big move upward or downward. This pennant has not quite reached its apex, but it is getting close. This means the move should come soon. The slow stochastic sub chart indicates that the overall direction of copper is probably downward right now. The ADX sub chart indicates that the -DI line is rising with a simultaneously rising ADX line and a falling +DI line. This means the downward trend is strengthening. The money flow index is indecisive, but its overall momentum seems to be downward at this time. Technically copper is set up to fall sharply.

The chart of Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX), a large copper miner, shows a very similar pattern.

(click to enlarge)Click to enlarge

FCX also has a long term pennant formation of about one year duration. This indicates that FCX has been storing up energy for a strong move in one direction. The slow stochastic sub chart shows that the stock is currently near oversold levels. This does not mean that it cannot continue to sell off, but it does indicate an inclination for a move upward near term. This would not actually defeat the above logic about copper. The pennant in both cases looks like it may have a bit farther to go to fully form. A near term move upward would allow it to get a bit further toward the pennant completion.

What really convinces me that this may be a downward move is the world economic fundamentals. The EU is in terrible shape. Greece is again threatening to collapse. If it does, this could cause a Lehman style banking event (or worse) in Europe. Many of the banks are involved in loans to Greek businesses and Greek real estate, even if some have by now divested themselves of their Greek sovereign debt (or some of it). Many experts estimate that Greece leaving the Euro would result in at least a 50% loss of asset values in Greece. This includes real estate. This would mean a 50% haircut for every bank that has lent buyers of Greek real estate or Greek businesses money.

This includes a lot of German, French, and Swiss banks. They have often had the best rates. If this happens credit may seize up, especially in the PIIGS. Then the PIIGS will fail even faster. This would push major economies such as Spain and Italy further into recession. It would push them closer to failing themselves. If one or both of these economies fail (or even another small economy such as Portugal's) a domino effect could be created. European countries could find themselves in a deep recession or even a depression. Greece is already in a depression. For this reason the EU may keep kicking the Greece can down the road.

However, it is getting harder and harder to do this. Greece presented its latest austerity package to parliament on Monday November 5, 2012. Many think it will be hard to get it approved. A vote is expected Wednesday November 7, 2012. Approval is necessary to unlock critically needed aid from the EU and the IMF. If the austerity package is not approved, the government (and Greece) may fail. The euro recently fell through its 200-day SMA. This is testimony to the worry this vote is creating about the whole EU monetary situation.

Any of the other PIIGS could become a problem quickly too. I am very worried by Spain's housing industry problems and consequent debt problems. These have in many cases been hidden for years. The EU banks stress tests tested only their trading books. This is only about 10% of their holdings. This did not include sovereign debt held for investment. It did not include approximately 90% of real estate loans. In the EU only the highest quality real estate loans are allowed to be used for MBS. These are the ones that are traded (in the trading books). These are the only ones that were stress tested.

A high growth housing market such as Spain was prior to 2008 will have lots of commercial and residential real estate loans that have lost a lot of value. These have been largely kept on the books all of this time at their face values. Many EU bankers were apparently hoping that given enough time, the real estate values would simply return. There is some logic to this strategy. However, Spain was far over built. It has literal ghost towns within commuting distances of large cities. The homes in these have often been vandalized. They are not worth their face value based on condition, much less on the current real estate values in Spain.

In addition, real estate values in Spain are accelerating downward with the new recession in Spain. This is worsening the credit situation. Admittedly, the banks have begun setting money aside for these problems. They have tried to recapitalize themselves. However, the problems still are not being fully recognized, and they will continue to be a problem for some time.

In addition, approximately 25% of the Spanish population is unemployed, and about 80% of Spaniards own homes already. Who will buy these excess homes? The EU is virtually in recession itself. The citizens of those countries will not be looking for vacation homes soon, especially not in ghost towns. This problem will get worse.

Data from the National Statistics Institute in Madrid September 14, 2012 indicated that Spanish real estate prices of houses and apartments had fallen 14.4% year over year. This kind of number wreaks havoc on any loan holder's balance sheet when such losses are finally recognized. The number of homes being sold is also declining. Some estimate that there are as many as 2 million unsold homes in Spain. When you consider this number remember that Spain has an economy about one tenth the size of the US economy. A comparable US number would be approximately 20 million unsold homes. This is a problem. Some experts estimate that this is a ten year supply of homes for Spain. There will be no quick solution to this problem.

The US has its own problems too. Q3 2012 earnings have been a big disappointment. Of 350 S&P 500 companies that had reported as of November 2, 2012 70% beat already lowered earnings estimates; but 60% missed on already lowered revenue estimates. This is not poor performance. It is atrocious performance. How can you get growth from declining revenues? Companies have already cut employees numbers and costs to the bone as a result of the recent recession. Further, the blended earnings growth rate is -0.5%. This isn't growth at all.

Guidance has been bad too. Only 18 companies have issued positive guidance. In contrast, 56 have issued negative guidance. The 56 is 76% of the companies that have issued EPS guidance. If this is the final percentage for Q3, it would be the highest percentage of negative guidance for a quarter since FactSet began tracking guidance in 2006. Further, many of the good results have come from financials. Most of these have already reported. One might expect the final figures to be worse than those I have cited above. Plus, this is not a one quarter phenomenon. Job growth isn't present.

Therefore, there has not been a large growth in the amount of money being spent on goods. How can companies grow under these circumstances? Perhaps they could grow through exports, but exports to a main US market, Europe, are decreasing due to economic problems there. This will not help companies grow earnings or revenues.

On top of all of this the fiscal cliff, tax-maggedon, and the necessity to again raise the US debt limit loom over the US Congress and the US economy. The CBO, a conservative estimator, has already said it expects a recession if the US goes over the fiscal cliff. As January 1, 2013 approaches without any substantive action by Congress, the likelihood of going over the fiscal cliff increases. The Congress spent several months just raising the debt limit a year or more ago. The chances that an interim Congress will agree on a compromise in time to avoid the fiscal cliff are virtually nil. Negotiations are only likely to begin in earnest when the new Congress people (Senators especially) take office in January 2013.

Some postulate that the Bush tax cuts pertaining to stocks will be extended another year. Perhaps this will happen, but this will not prevent the fiscal cliff. According to one study the US has already lost one million jobs due to the specter of the fiscal cliff. A National Association of Manufacturers report predicts that 6 million jobs would be lost through 2014 if the US actually goes over the fiscal cliff. It estimates that unemployment would skyrocket to 12%. One might ask how Congress could have let the fiscal cliff problem get this far? There is no answer other than callousness and stupidity. Thank your Congressman and Senators if you lose your job.

If I am correct that the US economy will experience bad problems or terrible problems due to the above, the Chinese economy will also worsen. At that point both of its biggest markets - the EU and the US - will be in recession. This will bring a "hard landing" into play for China. On top of this, China is changing leadership. It will have a harder time adjusting to new problems. It takes a while for any new person to learn his/her new job well. This should ensure severe problems in China.

It seems almost a certainty that Dr. Copper is right again. The direction of the copper at the end of the pennant almost has to be down based on the above fundamentals. It promises to be a big down move. The length of the pennant formation indicates how much energy has been stored up for a decisive move. This means that selling or averaging out of your copper holdings and copper mining stocks is probably a good idea. Aggressive traders may want to short FCX, although the timing may be tricky; and FCX does pay a 3.20% dividend. You will have to pay this if you short the stock (only one fourth of it per quarter). If you are unsure of exactly what will happen, you might just want to average out or sell.

As a further complication, there is often a pop upward after the US Presidential election. Some might want to wait this out. However, the copper pennant is approaching its apex; and most US Presidential election years don't have to contend with a fiscal cliff, tax-maggedon, and an EU credit crisis after an already weak growth year. Sometimes the obvious thing does happen in the stock market, despite all the pumpers, etc. This could be one of those times.

If you find the above argument at all compelling, you will want to get out of FCX soon. The same could be said for many other copper miners such as Southern Copper Corp. (NYSE:SCCO), BHP Billiton Limited (NYSE:BHP), Rio Tinto plc (NYSE:RIO), and Xstrata plc (OTC:XSRAF), which are some of the world's biggest copper miners. If you are thinking about shorting stocks, SCCO has a huge dividend of 28.50% currently. You may want to avoid it for this reason.

There is probably performance to go with that dividend too. You may be able to think of reasons not to short the others too. BHP has a less dramatic pennant formation than FCX. RIO has a still less dramatic pennant formation, which could almost be called a consolidation phase. I could go on, but you will likely want to stick to stocks which are heavily traded in the US, which XSRAF is not.

Note: Some of the fundamental data above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FCX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.