Is this the best indicator for value stocks?

The copper to gold ratio is trending higher as growing industrial production drives demand for copper – Photo: Shutterstock

The copper-gold ratio can offer a viable compass for investing in so-called value stocks or companies that appear undervalued in 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, versus gold, a precious metal that appreciates during periods of downturn. economic instability.

During the expansion phase of an economic cycle, the copper-gold ratio tends to increase as increasing industrial production stimulates the demand for copper. On the other hand, during a downturn, gold tends to outperform, which lowers the copper/gold ratio. As shown in the chart below, the copper-gold ratio is highly correlated to the US business confidence index.

Not surprisingly, this indicator shows a very close correlation with the performance of value stocks, or companies that trade at “discount” prices to their fundamentals and tend to outperform during expansions. economic.

What does the copper/gold ratio currently tell us about the health of the economy and the behavior of value stocks?

All: copper/gold ratio and US business confidence index

a chart showing the copper-gold ratio and US business confidenceCopper-gold ratio and US business confidence index – Credit: / Source: Tradingview

The copper/gold ratio explained

The copper to gold ratio measures the number of ounces of gold that can be purchased with one pound of copper.

Copper is an industrial metal widely used in the manufacture and production of machinery. It also has many applications in new and emerging green technologies, such as solar cells and electric vehicles.

The world’s largest consumer of copper is China, covering around half of global demand. Therefore, China’s industrial expansion is a major driver of copper demand.

Gold is a precious metal used in the jewelry industry, technology and for investment purposes by central banks and individual investors. Traditionally considered the safe haven par excellence, the demand for gold tends to increase in times of economic uncertainty or high 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 generally increases the copper to gold ratio as industries invest and increase production due to the confidence that household demand and consumption will increase.

In contrast, declines in the copper-gold ratio are often linked to a downturn in the economic cycle and a slowdown in production, or 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 referred to 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 used value investing extensively to create wealth.

Value stocks belong to industries with stable growth rates or with some pessimism about future growth given their current favorable valuations. Companies in the energy, industrial, financial or materials sectors are typical examples.

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Investors frequently use valuation measures such as price-to-earnings (P/E) ratio to determine whether 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 a stock is currently “sold” or has attractive market prices.

During periods of economic expansion, value stocks tend to outperform, especially in the early stages of the boom cycle, when rising demand and production boost companies that had been mostly ignored by the boom cycle. market.

Value stocks differ significantly from growth stocks, such as technology companies, which have high or expensive market valuations, because investors assume, and therefore expect, that these companies will continue to increase earnings at similar rates to growth. ‘coming.

The Vanguard Value ETF (VTV) is a traded index fund that tracks an index of large-cap value companies, including Warren Buffett’s Berkshire Hathaway (BRKb), financial firm JPMorgan Chase (JPM), healthcare company Johnson & Johnson (JNJ), health insurer UnitedHealth Group Inc (UNH) and consumer products maker Procter & Gamble (PG).

The iShares Russell 2000 Value (IWM) ETF is more of a representation of small-cap US companies, including cinema operator AMC Entertainment (AMC), car rental company Avis Budget Group (CAR), department store chain Macys (M) and oil companies and natural gas company Antero Resources (AR).

Copper/Gold Ratio and Correlation to Value Stocks

correlation between the copper/gold ratio and value stocksValue stocks and their close correlation to the copper-gold ratio – Credit: / Source: Tradingview

What the copper to 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 remained virtually stable in the first quarter of 2022.

As a result, gold has stopped underperforming copper in recent months, reflecting growing investor concerns about the sustainability of the current economic recovery cycle.

Rising inflationary pressures, geopolitical fears around the Russia-Ukraine war as well as a new wave of Covid-19 in China have been the main drivers of recent gold and copper price action.

If the economic cycle continues to deteriorate, the copper/gold ratio could decline from there, dragging value stock performance with it.

On the other hand, if the conflict in Ukraine and the inflationary pressures are resolved, the global economic recovery will continue, without the brakes to prevent the growth of the copper/gold ratio.

Chart: Copper/gold ratio and economic cycles

a graph showing the copper-gold ratio and the expansionary/contractual cycleHow the copper-gold ratio has fared over recent economic cycles – Credit: / Source: Tradingview

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Sallie R. Loera