Sunday, March 17, 2013

Why Commodities lead and Stock Markets follow - Case study : Copper and KLSE

As an astute investor we should know that we are now living in a more globalized and inter-connected world than the one that was 10 years ago. A drought in the U.S will result in higher prices of Soybean and Corn in the global market. The crash of the Dow Jones overnight will have devastating effects throughout the world markets the next morning. Similarly rising commodity prices will be bad for stock prices.

Why rising commodity prices bad for stocks?

Commodities such as Copper and oil are essential raw materials to many industries. They are the main ingredients in many of the products we buy. Whenever commodity prices go up there are two profound effects on the economy that will eventually affects the stock prices.

  1. Reduced earnings for companies. Due to the competitive business environment companies will find it very difficult to pass on their increased cost to consumers at their whims and fancy without losing sales. As a result companies that are unable to pass on their costs will have to resort to cost cutting measures in order to maintain their customer. This will result in lower margin and hence lower profits. Lower profits will translate to lower stock prices.

  1. If the higher costs are passed on to consumers then it will result in consumers paying more for these products and hence will have less money or disposable income to spend on other products. Since the economy depends a lot on consumer spending and a reduction in the consumer spending means there will be low or no growth (stagnant) in the economy. A slower economy will translate to lower sales for the companies and hence earnings. Since earnings is the main driver of stock prices, a reduction means softer stock prices.

So when the economy improves the demand for commodities such as copper and oil will naturally be on the upswing. In the law of supply and demand when demand exceeds supply in any given commodity the price will have go up. This will have the tendency to create an inflationary pressure and  thus will be reflected in higher prices of good and services. In other words it will create a higher inflationary effect on the economy. The authorities will not just sit tight and let inflation to create havoc in the economy. Sooner or later it will have to fight inflation by raising interest rates so as to cool down demand which will eventually help to bring down the prices of goods and services. As you know the effects of higher interest means lower stock prices due to the competition from alternative investments like term deposits and bonds.

Relationship between Commodity and Stock Prices?

The following are two charts that represents the price of Copper and the Kuala Lumpur Composite Index as from February 2010 till March 2013. As you can see from below there is a direct correlationship between them. Both chart was at the low during the June-July 2010 period. Thus when price of Copper is at the low so does the FBMKLCI. Again during the September 2011 and October 2011 both readings are at their lows.  Similar occurrences happened in May and November 2012 and also recently during the month of February 2013. The question is ‘whether these are pure coincidences’?  We doubt it.

This is only one small example that we have shown you and if you dwell deeper into different markets you will be amazed by their relationships. So the lesson that we can learn from here is that different markets are certainly inter-connected and it pays to study inter-market trends so as to improve our odds of success in trading the markets.

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