Traders are always looking for leading indicators that can predict the stock market’s return. Popular leading indicators include the Manufacturing PMI or weekly jobless claims, but commodities are also commonly used. Copper is frequently touted in the media as a leading indicator for stocks. Is it correct that copper is a leading indicator for stocks? Can we make a copper vs. stocks strategy?
No, copper is most likely not a good leading indicator for stocks. Our copper vs. stocks trading strategy might be due to luck or randomness.
In this article, we are going to look at why copper is considered a leading indicator, develop a copper vs. stocks trading strategy, and backtest it. Because copper is used in almost every industrial sector, weak demand is usually a sign of economic slowdown. Hence, it might be a useful indicator for the stock market.
We backtest trading ideas frequently. If you are looking for a short term trading strategy, please click on the link (we have made hundreds of backtests).
Why is copper considered a leading indicator?
Copper is used practically in all sectors of the economy, from homes and factories to electronics and power generation.
Moreover, the demand for copper is growing consistently every year because it’s a critical component of electric vehicles and green energy equipment such as solar panels. We can expect this to continue due to the so-called green shift of the economy.
Because of this, when demand for copper increases, meaning the price increases, it typically indicates a growing economy. When copper prices fall, it may signal an economic slowdown ahead. Because the stock market is discounting future earnings, copper might be a useful indicator.
Other ways exist to measure this (apart from price rises or falls). For example, the price of copper has widened to the biggest discount against its futures equivalent in almost two decades.
In other words, it is much cheaper to buy copper right now than a futures contract to have it delivered in 3 months (a kind of contango). This might signal investors and traders about a possible sudden weakening in global demand (?). (By the time you read this the current situation might be different, though).
Is Copper a leading indicator for stocks? Trading rules
The reasoning for why copper might be a leading indicator sounds reasonable, but is it supported by facts?
We developed a simple strategy to test this hypothesis. Let’s call it the copper vs. stocks trading strategy:
- If the last four-week return for copper is positive, buy SPY (S&P 500) for the following week, or
- If the last four-week return for copper is negative, hold cash for the following week.
There might be other trading rules that are better, but we chose these rules. Let’s find out how this backtest performed:
Is Copper a leading indicator for stocks? Backtest
We backtest the strategy using SPY (S&P 500) since year 2000. The data is not adjusted for dividends and splits. Here is the equity curve of the copper vs. stocks strategy:
Here are some metrics and statistics of the strategy:
- CAGR is 4.37% (buy and hold 6.48%)
- Time spent in the market is 47.30%
- Risk-adjusted return is 9.23% (CAGR divided by time spent in the market – 0.473)
- Maximum drawdown is -37.91% (Buy & Hold has 54.61%)
- The percentage of positive weeks is 57.68% (only measuring weeks where we were invested in SPY)
Looking at the results, it is hard to argue against the fact that the strategy performed decent. It has a decent return for the time invested in the market with smaller drawdowns than Buy & Hold. However, there is a very long time frame between 2008 and 2016 where the strategy did pretty much nothing. This is hard to stomach, and most traders would have abandoned the strategy by then.
That’s because copper fell more than 50% from its high in 2011 till 2016 and didn’t reach that level again until after the Covid crash. Meanwhile, stocks did not stop going up.
Copper and stocks correlation
Another way to look at it is to see whether the returns of copper in the past four weeks are correlated to the returns of SPY during the following four weeks.
If copper was a leading indicator for stocks, the correlation should be high because if copper’s last 4 weeks’ return was positive, SPY next four weeks’ returns should be positive as well.
However, as you can see in the following graph, they are not very correlated, especially between 2011 and 2016:
So, after all, we can’t really say that copper is a leading indicator for stocks. The strategy performance may just be luck.
Is Copper a leading indicator for stocks? – conclusion
To sum up, although the copper vs. stocks strategy performed well there is no concrete evidence that copper is a reliable leading indicator for stocks. Copper and stocks do not have a strong correlation. However, it can be more useful to help predict business cycles in the economy.
