Copper/gold ratio: Is it the best indicator for value stocks?
16:53, 7 April 2022
The copper-to-gold ratio can offer a viable compass for investing in so-called value stocks, or companies that appear undervalued on the market.
Traditionally used to gauge the health of the business cycle, the copper-gold ratio reflects the relative strength of copper, an industrial metal associated with economic expansion, against gold, a precious metal that appreciates during periods of economic instability.
During the expansion phase of an economic cycle, the copper-to-gold ratio tends to rise as increasing industrial production stimulates the demand for copper. In contrast, during a downturn, gold tends to outperform, lowering the copper/gold ratio. As the chart below shows, the copper-gold ratio is highly correlated with the confidence index of US businesses.
It is not surprising this indicator shows a very tight correlation with the performance of value stocks, or companies trading at "discount" prices relative to their fundamentals and which tend to outperform during times of economic expansions.
What is the copper/gold ratio currently telling us about the health of the economy and the behaviour of value stocks?
What is your sentiment on Gold?
Together: Copper to Gold ratio and US business confidence index
Copper-to-gold ratio and US business confidence index – Credit: Capital.com / Source: TradingviewCopper/gold ratio explained
The ratio between copper and gold measures the number of ounces of gold that can be bought with a pound of copper.
Copper is an industrial metal widely used in manufacturing and machinery production. It also has numerous applications in new and emerging green technologies, such as solar cells and electric vehicles.
The world's largest consumer of copper is China, covering about half of global demand. Therefore, China's industrial expansion is one of the main drivers for copper demand.
Gold is a precious metal used in the jewellery industry, technology and for investment purposes by central banks and individual investors. Traditionally considered the ultimate safe haven asset, demand for gold tends to increase in times of economic uncertainty or elevated inflation.
The copper-gold ratio is a reliable barometer that measures the relative strength of industrial activity against fears of economic recession or inflation.
Economic expansion typically increases the copper/gold ratio as industries invest and increase production because of confidence that household demand and consumption will grow.
In contrast, declines in the copper-gold ratio are often linked to a downturn in the business cycle and slowing production, or to an excessive overheating of the economy due to “bad” inflation, which has a negative impact on industrial activity.
What are value stocks?
Companies that trade at a discount to their intrinsic value are commonly known as value stocks.
If you're unfamiliar with these types of stocks, you've almost certainly heard of billionaire Warren Buffett, one of the most successful investors in history, who has extensively used value investing to build wealth.
Value stocks belong to industries with stable growth rates or with some pessimism about future growth considering their favourable present valuations. Companies in the energy, industrial, finance, or materials sectors are typical examples.
Investors frequently use valuation metrics such as the price to earnings (P/E) ratio, to determine if a stock is undervalued or overvalued. This ratio is calculated by dividing the company's share price by its earnings. A low P/E ratio is one of the criteria that suggests that a stock is currently "on sale" or has appealing market prices.
During periods of economic expansion, value stocks tend to outperform, particularly in the early phases of the boom cycle, when rising demand and production boost enterprises that had been mostly ignored by the market.
Value stocks differ considerably from growth stocks, such as technology companies, which have high or expensive market valuations because investors assume, and hence discount, that these firms will continue to expand their earnings at similar rates in the future.
The Vanguard Value ETF (VTV) is an exchange traded fund that reflects an index of large cap value companies, including Warren Buffett's Berkshire Hathaway (BRKb), financial firm JPMorgan Chase (JPM), health care company Johnson & Johnson (JNJ), health insurer UnitedHealth Group Inc (UNH), and consumer products maker Procter & Gamble (PG).
The iShares Russell 2000 Value ETF (IWM) is instead a representation of US small-cap value companies, including cinema operator AMC Entertainment (AMC), car renter Avis Budget Group (CAR), department store chain Macys (M), and oil and natural gas company Antero Resources (AR).
Copper/gold ratio and correlation with value stocks
Value stocks and their tight correlation with copper-to-gold ratio – Credit: Capital.com / Source: TradingviewWhat the copper/gold ratio says and what to expect next
After nearly doubling in value between August 2020 and October 2021, coinciding with the extraordinary acceleration of the post-Covid-19 global economic recovery, the copper-gold ratio has stayed virtually steady in the first quarter of 2022.
As a result, gold has ceased to underperform copper in recent months, mirroring investors' growing worries about the sustainability of the present economic recovery cycle.
Growing inflationary pressures, geopolitical fears around the war between Russia and Ukraine as well as a fresh wave of Covid-19 in China, have been the major drivers affecting the recent price action in gold and copper.
If the economic cycle continues to deteriorate, the copper/gold ratio may decline from here, bringing the performance of value stocks down with it.
On the other hand, if the conflict in Ukraine and inflationary pressures are resolved, the global economic recovery will move forward, without the brakes to stop the copper/gold ratio from growing.
Chart: Copper/gold ratio and economic cycles
How the copper-to-gold ratio performed during the latest economic cycles – Credit: Capital.com / Source: TradingviewMarkets in this article
