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June 09, 2006

Base Metals Technicals 2
by Adam Hamilton

Some of the most fascinating and amazing market action this year has occurred in the base metals. They have blasted stratospheric in mighty parabolic surges, exhibiting tremendous volatility that even dwarfs that of the stock markets. And now they are largely retreating in healthy bull-market corrections necessary to bleed off their earlier speculative excesses.

This jaw-dropping volatility in the base metals is even more remarkable considering how young their bull markets are. Several years ago the base metals, which in the markets are defined as any metal that is not considered precious, were languishing near secular lows. Not even the contrarians who were zealously trading the precious metals at the time cared about the base metals.

Yet regardless of their lack of sexiness, the laws of supply and demand function just as well in the base metals' realm. World demand for base metals was soaring on the back of the industrialization of Asia, but new mines were not being constructed since prices were too low to make supplying base metals worthwhile. The resulting global supply crunch has driven base metals to levels unimaginable only a few years ago.

The past several months since I wrote my original essay in this series have been some of the most exciting in history for the base metals, so this week I want to update my charts and analysis. Before I delve into this, I'd like to relay an interesting anecdote that happened to me earlier this week that puts this analysis in context.

In recent newsletters for our subscribers, I have been discussing the ongoing metals corrections extensively. Corrections are inevitable, every bull market in history has flowed and ebbed, taking two steps forward in dazzling uplegs before retreating one step back in necessary corrections to restore balance to sentiment. These steps back are immensely valuable as they provide the best buying opportunities of any bull market.

A few days ago in our Zeal Speculator alert service, I was discussing potential interim-bottoming targets for copper's ongoing correction. One gentleman wrote in after the alert was published and he was not happy with my thoughts on copper's probable near-term fortunes. After telling me I was smoking something, he pointed out that copper is ultimately in short supply, that China cannot build its infrastructure without copper, that the fleets of hybrid vehicles being produced worldwide each use large amounts of copper, and on and on.

He was absolutely correct in his fundamentally bullish arguments for copper. Fundamentally the base metals all look outstanding. Their supplies were neglected for decades and now the rise of Asia is adding unprecedented demand. And it will probably take at least another decade or so before enough new base metals mines come online to address this structural deficit, so prices should continue to rise on balance in the meantime. But long-term fundamental arguments mean nothing in the face of short-term technicals.

No markets rise in a straight line forever and neither will the base metals. As the base metals technicals clearly show, they became radically overbought by any standard in the last few months. When speculators get too euphoric and drive prices to extremes, corrections are necessary to bleed the greed out of the markets which ensures the bulls' ultimate longevities are not damaged or compromised.

Corrections are not threats to investors and speculators, but opportunities to realize profits and reload positions at the resulting interim lows. So as you digest these base metals technicals, get in the crucial speculator mindset of seeing corrections as a gift you can capitalize on to buy bargains at the coming interim lows, not a threat. And realize that bearish short-term technical arguments never impair long-term bullish fundamentals.

Copper is the undisputed king of base metals. In the heavily wired Information Age, this efficient conductor is ubiquitous in everything from buildings to cars to electronics. It is one of the most essential commodities for modern civilization. In the markets, copper usually sets the tone for the rest of the base metals. As such, copper is the best place to start examining the current base metals technicals.

Copper has had an absolutely amazing bull run in the last several years. Three years ago this week it was trading under $0.77 per pound. But at the end of its latest parabolic surge in late May, it closed near $4.08! This 430% gain is breathtaking and illustrates just how incredible the base metals' performances have been. The majority of these dramatic gains, however, have accrued only since February which is just far too rapidly in the grand scheme of things.

Back in 2003 copper was in a nice solid uptrend. It eventually broke out in late 2003 and early 2004 with a very impressive 58% surge in only 67 trading days. This secular awakening of copper put it on the map again for many speculators. China was starting to bid on copper worldwide which drove prices up and speculators jumped on for the ride, fanning the flames. After this first major upleg, copper modestly corrected 18% over the next 54 days before entering its next major uptrend channel that lasted until late last year.

Back at the time it unfolded, copper's 2003/2004 upleg looked vertical, totally unsustainable. But copper really didn't correct too radically after such a powerful surge. After an initial modest correction it started consolidating and grinding sideways to higher. This behavior illustrated that pure global supply and demand fundamentals were a much bigger driving force behind copper's first upleg than speculative fervor.

Fast forward to last summer. In May 2005, copper was trading just over $1.42, already back above its early 2004 highs. Over the next year or so, copper would ultimately run 187% higher over 257 trading days. This occurred in two distinct phases, an initial 64% upleg running into early February and a secondary 91% parabolic surge that erupted in late February. The latter is the reason why copper is almost certain to correct.

Up until February, copper's 64% run over 183 trading days was totally normal. It was certainly a strong upleg, but it was justified because global copper demand growth continued to exceed supply growth. If copper had topped on an interim basis in early February at $2.34 as it probably should have, I would have expected a modest correction leading into a long sideways consolidation as this metal had done in 2004. But then something incredible happened.

Speculators, largely hedge funds, started deploying enormous amounts of capital into commodities futures. At the time oil, gold, and silver were all strong which was spawning interest in the commodities realm outside of the usual players. Much new capital poured into hedge funds, which promptly deployed it in futures and drove base metals prices parabolic. Copper itself rocketed up 91%, nearly doubled, in just 60 trading days!

This magnificent parabolic surge certainly sticks out on this chart. It was like copper looked normal until February then the character of its bull totally changed. The problem with parabolas is they are never sustainable. As a price shoots vertical on a chart and nearly doubles in a short period of time, the amount of capital necessary to continue generating gains of this scale grows exponentially. Without enough continuing buying to offset the selling of the speculators locking in their gains, the only thing the parabola can do is collapse.

And so far it looks like this collapse has started for copper. The parabolic collapse in this case is certainly not going to end the copper bull, but just close the book on a particularly exuberant upleg. Through this process of correcting, copper will bleed off the excessively optimistic sentiment so common lately and restore balance. Sooner or later this metal will bounce and provide an awesome opportunity to add more longs including the stocks of elite global copper producers.

No matter how bullish copper's fundamentals are, a vertical 91% gain in just three months is beyond the realm of reason or sustainability. Industrial users that drive true physical demand cannot bid up prices fast enough to spawn a parabola. Only speculators can. But speculators, since we don't actually need or want the physical copper, can exit long positions just as fast and drive a symmetrical correction. Since this has already started, extreme caution is in order for copper until its price starts to stabilize again.

Interestingly zinc's parallel parabolic surge is even more extreme than copper's! This metal skyrocketed 98% in just 58 trading days and ultimately crested at unthinkable levels over twice as high as its baseline 200-day moving average. Like in copper though, such incredibly fast surges leading to verticality are never sustainable. Zinc's necessary correction to rebalance its sentiment has already started.

This chart is utterly amazing! If anyone would have told me a year ago that zinc, a relatively obscure base metal compared to the headline commodities, would rocket up 228% in just one year I would have laughed. Yet here we are. Such an extraordinary move in such a short period of time, especially the final double since February, has carved one of the most textbook-perfect parabolic blowoff patterns I have ever seen. Such a mighty surge will absolutely have consequences.

Now what are the odds that zinc was so horribly undervalued fundamentally at $0.91 in February that it had to double over the next few months to reach fair value on a pure supply and demand basis? Pretty slim. Industrial users of zinc know about how much they will need months or years in advance so they gradually buy and lock in their prices with futures. It is only speculators that can and will buy aggressively enough to spawn a true parabola, an enormous surge in a very short period of time.

At any time, even at the apex of a parabola, prices can only do one of three things, rise, flatline, or fall. To rise, regardless of where a price is, new buy orders have to continue to outnumber sell orders. Thus for zinc's parabola to extend higher, some big buyers have to come in and not only absorb all the speculative sell orders from funds realizing their profits but provide marginal demand on top of that. As the 17% initial slide in zinc over just 6 trading days has shown, this apparently is not going to happen.

The second possibility is the parabola flatlines, a new price plateau is reached and prices trade sideways. For this to happen, enough buy orders have to come in at these stellar zinc prices to totally offset sell orders from speculators locking in their immense profits. This almost never happens though. If you wanted to buy zinc either as a speculator or an industrial user, and you thought prices were heading lower, why not wait a couple weeks or months to try and get a better price? No one wants to buy once parabolas start faltering.

Hence the final, and most likely by far, outcome after a parabola is a sharp correction. At the top, prices seem crazy high to everyone. Speculators sell aggressively to lock in their profits and sell orders dwarf buy orders so prices start falling. These falling prices spook other speculators who soon join in lest they give back all of their gains. This cascading selling starts damaging sentiment. Buyers don't come into the market again in volume until prices start to stabilize after the plunge frightens most of the potential sellers into selling, or shakes out the weak hands.

No matter how bullish zinc's long-term fundamentals may be, it is not immune from these temporary psychological extremes that dominate short-term market action. If you want to go long zinc or buy zinc miners, the best time to do it is after a correction when fear is high, not near a parabolic top where euphoria runs rampant. Zinc, like copper, simply cannot sustain nearly 100% gains in just a few months. They are too extreme.

Nickel, which is primarily used to make alloys like stainless steel, has also joined in the recent extraordinary base metals action. Interestingly though, nickel's recent runup was nowhere near as extreme as those of copper and zinc. Nickel, thanks to its earlier 2003 parabolic ascent, also illustrates the potential aftermath of a parabola in the midst of a strong bull market.

In 2003 nickel soared, up 130% in just 187 trading days. The apex of this vertical move drove it to extremely high levels relative to its baseline 200dma, over 1.75x above it. While fun at the time for speculators long nickel, the extreme speculator greed necessary to drive parabolas has inevitable consequences. Thus in early 2004 nickel corrected and fell sharply, ultimately bleeding off 41% over 92 trading days.

It is important to realize that this correction, while vicious, in no way jeopardized nickel's ongoing secular bull market. Nickel corrected back down to its old support line, which was under its 200dma that had been jacked up faster than usual due to its 2003 parabola. And after its 2004 correction bounced, nickel established an excellent new uptrend and continued moving higher for over a year. This event is crucial as it illustrates how a short-term parabola and its aftermath can be fully digested in the midst of a secular bull without threatening to end the bull prematurely.

My best guess for the outcome of the current copper and zinc parabolas is they will follow a similar course to nickel's earlier example. They will correct and grind lower for several months or so, ultimately falling under their 200dmas since those 200dmas were rising abnormally rapidly in response to their parabolas. These bounces could even go as low as the latest support lines of copper and zinc. I'll certainly be watching for these next interim lows wherever they happen as I am really excited to redeploy into base metals miners when they are once again technical bargains.

Back to nickel's recent technicals, it was up 101% over 144 trading days since late last year. Now this is certainly a big upleg, even a quasi-parabolic surge, but to me it doesn't quite feel fully parabolic. There is a big difference between a price doubling in three months and it "merely" shooting 59% higher. Nickel is and ought to be correcting after such euphoria, but ultimately its correction should be considerably milder than copper and zinc because its preceding parabolic pattern was so much less extreme.

If you aren't happy with all these technicals pointing to probable ongoing corrections in copper, zinc, and nickel, then you should be pleasantly surprised by lead. Lead's own quasi-parabolic surge topped in early February and it has been correcting ever since, off 30% so far. Unlike the other base metals, lead is already back down to its technical strong-buy zone below its 200dma from whence its next upleg is likely to launch.

Lead is really interesting and also offers insights into the likely near-future paths of copper and zinc today. In 2003 and early 2004 lead soared 127% higher in a strong upleg over 215 trading days. While the end of this particular rally came close, it never quite went vertical and hence it doesn't feel like a true parabola to me. But the consequence of this immense strength was a sharp 29% correction over about seven weeks. Yet immediately after this correction rebalanced sentiment, lead started marching slowly higher again in a new uptrend. The 2003/2004 parabola and its aftermath didn't hurt the secular bull.

Fast forward to 2005, lead started powering higher again last summer just like the rest of the base metals. For some reason it peaked in early February though and did not participate in the strong secondary surge from late February to late May that drove the rest of the base metals straight up. As for reasons, I've yet to hear a really convincing thesis that could explain this lead lethargy. All I know is that lead is largely unloved and politically incorrect and speculators didn't flood into it in recent months like they did with the other base metals.

The result of this lack of secondary-surge participation is lead is already technically cheap today, and it may be at or nearing the end of its correction as long as it isn't sucked into a sympathetic slide with the other base metals. Unfortunately this technical bright spot in the base metals is not easy to capitalize on. Unless you trade futures directly on the London Metal Exchange, it is hard to buy lead or lead options.

And to the best of my knowledge there is still only one publicly traded pure-play lead miner in the world. While we recently recommended it in our newsletters, it is not yet traded in the US stock markets. Thus unfortunately this lead weakness is not as easy to capitalize on as the eventual interim bottoms in the other base metals will be. Indeed it is quite possible that one reason lead didn't participate in the secondary base metals surge in recent months is because it is so difficult for American speculators to trade it directly or indirectly.

The final major base metal is aluminum. While it did mirror the surges of copper and zinc, in magnitude terms it didn't even come close to seeing similar gains. With aluminum's recent secondary surge only up 38%, I would classify it as a strong upleg and not even a quasi-parabola. This also suggests that aluminum's necessary correction to rebalance sentiment should be considerably milder than copper's or zinc's.

In light of aluminum's more sedate gains since last summer and February, it is ironic that its young correction is leading, at the moment, the base metals that participated in the secondary surge. Aluminum was down 20% by Wednesday night, the data cutoff for this essay, compared to 17% for zinc, 15% for copper, and 11% for nickel. This anomaly probably won't persist though, as the metals with the most extreme parabolic surges should ultimately suffer through the biggest percentage corrections.

The base metals technicals are very interesting today. They generally show extraordinary surges in these metals, especially since February, driven by pure speculative fervor. They now reveal corrections that are already well underway. But they also show that parabolic surges in base metals have happened in the past and they did not damage their ongoing secular bulls. While they did need to correct for a season to rebalance sentiment, their bullish uptrends resumed afterwards none the worse for wear.

In light of these base metals technicals, I believe the best course of action today is to expect further corrections in most of the base metals. They became far too overbought in the past month and they need to correct to rebalance sentiment. On the bright side, ultimately these corrections will spawn the next interim lows that will provide the best buying opportunities before the next major base metals uplegs erupt.

At Zeal we are always watching the base metals and waiting for this opportunity, researching the most promising base metals miners on the planet. When the base metals technicals look highly favorable for going long again after these corrections mature, we are planning to redeploy into elite base metals stocks in a big way. When the appropriate time comes, we will outline and recommend these actual trades in our newsletters for our subscribers. Please subscribe today so you don't miss these coming major buying opportunities!

In addition to exclusive access to what we decide to trade and when as these coming base metals interim bottoms materialize, our subscribers also gain exclusive access to the large selection of private charts on our website. This collection includes large high-resolution versions of base metals technicals charts that are updated weekly so you can follow the progress of these ongoing corrections yourself.

The bottom line is most of the base metals, regardless of how wildly bullish their fundamentals may be, simply grew far too overbought in May. A flood of new speculative capital drove the metals up, parabolic in some cases, to crazy levels that are not sustainable over the short term. All bull markets flow and ebb, and the base metals are no exception. Their latest ebbings have arrived.

But on the bright side these corrections will ultimately lead to the best buying opportunities in the base metals and base metals stocks since last summer. As these metals' histories show, even short-term parabolas and their aftermaths are not a threat and will not derail long-term secular bulls driven by global structural deficits in metals production.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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