Sunday, July 18, 2021

"Understanding Copper's Link with the Economic Cycle"

For folks awaiting an entry point for a directional bet in the futures, not yet.

From Verdad Advisers:

Doctor Copper
To prepare for a sea war with France, in 1807, Britain re-hulled the Royal Navy fleet with copper. This additional demand caused copper prices to more than double, sending them to the highest level of real prices on record ($27,400/ton in today’s dollars versus current price of ~$10,000/ton).

This episode marked one of the first copper booms and busts in recorded history, but it certainly was not the last. A cursory glance at copper’s price history reveals its highly cyclical nature.

Figure 1: Real Copper Prices (1850–2016)
Source: USGS, Winton
The likely reason for copper’s cyclicality is that copper, like oil, is linked to the economic cycle and the aggregate level of business activity due to its widespread applications throughout the economy. Copper is sometimes referred to as “Doctor Copper” because of its ability to gauge the health of the economy and foretell turning points in business activity. In good times, when businesses expand and consumer spending is high, more copper is needed for factories, cars, or consumer electronics, which is why copper should perform best at the beginning of business cycles, when the economy is booming.

To test that hypothesis, we looked at three-month forward returns of copper futures by three-month trailing changes in the high-yield spread. A falling high-yield spread suggests the economy is expanding, while a rising high-yield spread suggests the economy is slowing down.
Figure 2: Annualized 3M FWD Returns of Copper Futures by Quartile of HY Spread Change
Source: Bloomberg, FRED

Historically, copper has performed best when the high-yield spread was falling, a proxy for a growing economy, and worst when the high-yield spread was rising, a proxy for a slowing economy. Armed with this insight, we replicated the simple strategy that we had previously created for oil (see On Oil) and applied it to copper: if, over the last three months, the high-yield spread has fallen, then our strategy goes long copper futures. In the event of rising spreads, we tested three alternative scenarios: the first one involves keeping the capital out of the market entirely when not invested in copper futures (“L/Out”); the second scenario goes long 10-year US Treasurys when not invested (“L/10Y T”); and the third scenario adopts a shorting component based on the same high-yield signal, which ensures that the investor is either long or short copper futures at all times (“L/S”).

Below we compare the performance of this strategy and its various constructions with a simple buy-and-hold approach in copper.
Figure 3: Performance Indicators for HY Strategy with Different Combinations (1989–2020)
Source: Bloomberg, Verdad

Evidently, timing the business cycle based on the high-yield spread dramatically improves copper performance. In the “L/Out” scenario, when the portfolio earns 0% nearly half the time, the signal helps improve performance by 300bps while reducing drawdowns by a third. Similar to our results for oil, the winning strategy is to go long 10-year Treasurys when spreads are rising, as doing so produces the highest returns, lowest drawdowns, and highest Sharpe ratio of all four combinations.
We can then explore how this strategy would perform within the context of a traditional portfolio. Below, we compare the returns of a 60% stock, 40% bond portfolio to a portfolio comprised of 60% stocks and 40% the “L/10Y T” copper strategy.

Figure 4: Strategy in Context (1989–2020)....
 Previously from Verdad: 

And back in the before times, January 2020, FT Alphaville caught a nice idea from Verdad's founder, among others: 

...One particular point, made by investors such as Verdad Advisers’ Dan Rasmussen, is that private equity returns are fundamentally the same as those for leveraged, mid-cap public equities. The only difference being that volatility in a private equity portfolio, due to the owned businesses having no day-to-day prices, is masked....