Fundamental analysis Market interconnections

The Impact of the Copper/Gold Ratio on Stock Markets

Anton Volkov 07 July 2022 219 4

Intermarket analysis examines the relationship and influence on each other of various segments of the financial market: currency, stock, commodity, etc. One of the analysts' tools is a ratio calculated by dividing the price of copper by the price of gold.


The copper/gold ratio is widely used for intermarket analysis. The essence of comparing these values is as follows:


  • Copper is an industrial metal. The price of it actively rises in the conditions of economic growth or on the expectations of this growth. It behaves procyclically in relation to the state of the economy: the price rises against the backdrop of economic growth and falls during a recession.


  • Gold is a classic defensive asset. It shows growth in conditions of high economic uncertainty and rising inflation. It behaves counter-cyclically in relation to the state of the economy: economic growth causes a fall in the price of gold due to the outflow of liquidity into riskier assets.

 

In terms of their role in the economy, copper and gold prices should move in opposite directions. Accordingly, the change in the copper/gold ratio reflects the current or expected state of the economy:

 

  • Growth of the coefficient - growth of the economy


  • Decrease in the ratio - slowdown in the economy or recession

 

In this study, we will consider whether the copper/gold ratio can be used as a leading indicator for trading in global stock markets.

Hypothesis
To conclusion

A decrease in the copper/gold ratio leads to a fall in the stock market. Accordingly, an increase in the copper/gold ratio leads to an increase in the stock market.

К выводам
Data used

Historical data of gold futures quotes.

Historical data of copper futures quotes.


Historical data of world stock indices' quotes:

  • The USA: Dow Jones 30, S&P 500, NASDAQ 100
  • Germany: DAX 30
  • France: CAC 40
  • Japan: Nikkei 225
  • The UK: FTSE 100
  • Russia: MICEX, RTS


Timeframe – D (daily).


Period - from 1990 to February 2022. For indices with the beginning of trading after 1990, respectively, since the beginning of trading to February 2022.


There are 8,117 values in total.



Strategy



Entry into the market - at the opening of Monday.

 

Exit from the market:

  • On Friday of the 1st week (week of entry into the market)
  • On Friday of the 2nd week
  • On Friday of the 3rd week
  • On Friday of the 4th week
  • At the opening of Monday when the opposite signal appears

 

If Monday is a day off, entrance on Tuesday of the same week.

If Friday is a day off, exit on Thursday of the same week.

 


With the growth of the copper/gold ratio, we buy stock indices.

With the decrease of the copper/gold ratio, we sell stock indices.



The strategy will be evaluated according to the following criteria:



  • The average rate of return reflects the relative change in the quotes of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, a negative one indicates a loss. 


The average rate of return (D) of a financial instrument is calculated using the formula:


D = Σ P (%) / n,


where:

n is the number of trades;


 

P (%) – the percentage of change in the quote of a financial instrument at the time of fixing a position, is calculated as follows:

 

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

 

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

 


  • The total rate of return (TD) is the sum of the profits from all trades. The greater the value of the total rate of return, the greater the profit brought by the signal during its testing period. 


  • Maximum drawdown (MaxDD) is the maximum loss in percentage terms from fixing unprofitable trades for the entire testing period. The lower the value of the maximum drawdown, the better the trading signal works.


MaxDD = | min ( DD1: DDn ) |

DDn = TDn – max ( TD1: TDn )


where:

 

n – number of trades;

D – rate of return;

TDn – total rate of return of n trades;

DDn – drawdown at the time of closing the n-th trade;

MaxDD – maximum drawdown.



Analysis of the obtained results



Let's look at the copper/gold ratio chart:

It can be seen that the coefficient behaved as a leading indicator in the run-up to a number of crises in the global economy:


  • Asian financial crisis (1997-1998). The copper/gold ratio reached its local maximum of 0.00359 on June 18, 1997, after which it began to decline. The beginning of the crisis is considered to be a sharp devaluation of the Thai baht on June 30, 1997. Thus, the delay between the appearance of the signal and the beginning of the crisis was a little less than 2 weeks.


  • The global financial crisis of 2008. The copper/gold ratio reached its local maximum of 0.00429 on August 25, 2008, after which it began to decline. The bankruptcy announcement of Lehman Brothers on September 15, 2008, is considered the beginning of the crisis. Thus, the delay between the appearance of the signal and the beginning of the crisis was 3 weeks.


  • The crisis caused by the coronavirus pandemic. The copper/gold ratio reached its local maximum of 0.00189 on December 25, 2019, after which it began to decline. A significant reaction of global financial markets to the spread of the coronavirus manifested itself in late January-early February 2020. Thus, the delay between the appearance of the signal and the beginning of the crisis was at least 4 weeks.

 

Indeed, the copper/gold ratio dynamics is a leading indicator of crisis phenomena in many cases. But can the ratio correctly predict the dynamics of global stock markets? Especially considering that the behavior of the financial market itself is a leading indicator of the global economy.

 

Let's consider the results of the strategy with an exit on the 1st, 2nd, 3rd, 4th week after entering the trade:

For all considered stock indices, excluding Russian MICEX and RTS, the strategy is ineffective for any exit option.

 

The MICEX and RTS indices show significant levels of rate of return, 0.4% and 0.34% when exiting a trade on the 1st week after entry.

The maximum drawdown values for the MICEX and RTS indices (114.31% and 107.4%) indicate a very high-risk degree of the considered strategy use. Such a level of risk with an average rate of return of only 0.4% and 0.34% does not allow the strategy to be considered effective in these cases as well.

 

Further, let's consider the results of the strategy with an exit on the opposite signal:

In general, the results are similar to the results of the strategy when exiting the trade on the 1st, 2nd, 3rd, 4th week after entry: only the Russian MICEX and RTS indices show a significant positive rate of return.

For the MICEX index, exit on the opposite signal allowed not only to increase the average rate of return of the strategy (from 0.4% to 0.71%), but also to reduce the maximum drawdown level (from 114.31% to 99.34%). The effectiveness of the strategy for the MICEX index has increased significantly.

 

For the RTS index, exit on the opposite signal led to an increase in both the average rate of return (from 0.34% to 0.42%) and the maximum drawdown level (from 107.4% to 150.72%). This does not allow the strategy to be considered effective.

Conclusion

The use of data on changes in the copper/gold ratio as a signal for making transactions in the stock markets of developed countries has shown low efficiency. The average rate of return for the considered stock indices of the USA, Germany, France, the UK and Japan does not reach a significant level.


For the Russian MICEX and RTS indices, the strategy shows a significant level of rate of return when exiting a trade on the 1st week after entry, as well as when exiting on the opposite signal.


At the same time, the high level of maximum drawdown does not allow the strategy to be considered effective for the RTS index, as well as for the MICEX index, if the trade is exited on the 1st week after entry.


The effectiveness of the strategy for the MICEX index has been revealed with the option of exiting the trade on the opposite signal.

Detailed results are shown in the Appendix:

XLSX (0.86 MB)The impact of the copper_gold ratio on stock markets.xlsx

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