Can Big Jump In Metals Offer Stock Market Trading Clues?

The precious and industrial metals markets have had a significant rally since last fall. How might it impact your portfolio and trading strategy?

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The stock market is up since the start of 2017, but the metals sector is up even more. Heightened investor uncertainty about the health of the stock market uptrend and concerns about inflation are two signals that precious and industrial metals markets might be flashing.

Gold is traditionally thought of as a hedge against a declining stock market, says JJ Kinahan, chief market strategist at TD Ameritrade. "The VIX has been relatively flat lately and some are turning to gold instead,” Kinahan says.

Like a canary in the coalmine, gold can also be useful for sniffing out a potential rise in inflation. Gold is seen as a leading indicator of inflation risk, Kinahan says. "We’ve had cheap money for so long, many believe that, if the economy picks up, inflation is a real risk," Kinahan says.

Since the start of 2017, near-month Comex silver futures have posted a healthy 11.92% gain, an industrial metal - copper futures chalked up a 11.34% gain and gold futures have posted a 6.25% return. That compares to the 3.79% gain in the S&P 500. 

Markets Are Intertwined

Market relationships can be likened to a mechanical balance scale with two pans suspended on either side of a fulcrum—when one side goes up, the other side goes down. Some market relationships are similar.

Case in point: the gold and silver markets generally have a negative correlation to interest rates, says Sam Stovall, chief investment strategist at CFRA. That simply means a rise in interest rates tends to have a negative influence on metals prices.

Rising interest rates can be seen as competition for metals, which pay no interest or dividends, but do have storage costs. Following a post-election Treasury yield spike, the yield of the 10-year note has eased off its recent peak at 2.62%, dropping as low as 2.32% last week.

Pointing to the negative gold-interest rate correlation, Stovall says, "the retrenchment in interest rates has benefitted precious metals."

The recent gains in the gold and silver markets could also reveal some investor jitters about the outlook for the stock market. "The attraction to gold is also related to uncertainty about this bull market, which will hit its 8th birthday on March 9. That would make it the second longest bull market since World War II," Stovall says.

Triple Threat Warning System?

Even for those who are not trading precious metals, the direction of the markets can offer potential clues to equity investors.

"I like to look at gold in sync with VIX and government bonds,” Kinahan says. “When I see the three of them headed higher together, I generally use that as a warning system that there could be trouble ahead for stocks - as those are areas investors turn to when they are nervous," he says.

Dr. Copper’s Counterargument?

Copper is another metal that has posted strong gains since the start of 2017, with gains just a smidge above 11% in the past six weeks. Copper is a widely used industrial metal with many applications in construction and manufacturing including plumbing, electrical, heating and cooling systems and automobiles. Nicknamed "Dr.Copper," the trend in this industrial metal can be used as an indicator for global economic activity.

The recent jump in copper prices suggests the "world believes that U.S. economic growth continues to improve and that we are not headed for a recession," Stovall says.

Investing Themes

Within the materials sector, gold stocks have posted a 10.5% gain since the start of the year and copper stocks are up 19.8% through Feb. 10.

"The miners have had a good year so far. They have a high correlation to the underlying, similar to the energy sector, says Kinahan. The underlying in this case would be gold, silver or even copper. "Because of this, many will play the miners as a synthetic way to play the underlying," Kinahan says.

If the metals sector rise is a signal the economy is strengthening, investors can consider manufacturing and housing stocks, Kinahan says. "Those sectors usually perform well in improving economic environments.” However, Kinahan warns, if the metals are rising as a warning signal for future inflation, then investments in the metals themselves or the mining stocks may make sense.

Investors looking to capitalize on the trends of these strong moves in the metals markets, could also investigate sectors that benefit from an overall improving economic environment, Stovall says. He points to the industrials, materials, consumer discretionary, financials and technology sectors as those which stand to benefit from the continued economic growth that copper might be signaling.

Trading Themes

The more active trading crowd could explore pairs trading, Kinahan says. The idea is, instead of taking pure up/down risk, pairs trading allows an investor to take relative strength risk in two highly correlated commodities, Kinahan explains.

That simply means "buying one and selling the other. They both may go up, but you want the one you buy to go up faster than the one you sell.  If they both go down, you want the one you buy to go down slower than the one you sell." 

Gold vs. Silver, 2017

FIGURE 1: GOLD (RED/GREEN CHART) VS. SILVER (PURPLE CHART).

Chart source: The thinkorswim® platform from TD Ameritrade. To view gold futures, under Charts tab, click /GC. To add silver, click Studies > Add Study > Compare > Add Symbol > /SI. For illustrative purposes only. Past performance does not guarantee future results.

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