Do investors view industrial metal price changes differently during good times and bad times? In the August 2010 draft of their paper entitled “Return Predictability When News Means Different Things in Different Times”, Ben Jacobsen, Ben Marshall and Nuttawat Visaltanachoti explore how the power of aluminum, copper, lead, nickel and zinc price changes to predict stock returns differs between economic expansions and contractions. For the U.S., they consider two indicators of the economic state, NBER business cycles and the Chicago Fed National Activity Index. Using futures prices for aluminum, copper, nickel, lead and zinc since 1991, 1977, 1995, 1977 and 1991, respectively, levels of the Goldman Sachs industrial metal index since 1977 and contemporaneous data for the S&P 500 Index and 13 economic indicators through June 2010, they find that:
- Industrial metal price increases predict higher stock market returns during contractions, arguably because they indicate earnings growth.
- Industrial metal price increases predict lower stock market returns during expansions, arguably because they indicate economic overheating (inflation and a higher earnings discount rate).
- The directions of prediction are consistent for all five industrial metals, but aluminum and copper provide the strongest signals.
- This asymmetric predictive power is economically substantial. During the five years ending June 2010, a simple out-of-sample, (retrospectively) real-time monthly trading rule that invests in stocks (Treasury bills) when the change in the Goldman Sachs industrial metal index predicts an equity return greater than (no greater than) the risk-free rate generates returns as high as 0.73% per month, easily beating a buy-and-hold strategy. This rule uses the Chicago Fed National Activity Index to indicate whether the economy is expanding or contracting each month.
- Industrial metal price changes exhibit predictive power for stocks distinct from the combined predictive power of 13 economic indicators.
- Aggregating data across economic expansions and contractions generally suppresses evidence that industrial metals lead the stock market, but the relationship may be positive, negative or nil depending on the relative frequency of expansion versus contraction states in the sample.
- Similar findings hold for the majority of European Union member countries.
In summary, evidence indicates that investors may be able to exploit industrial metal prices as a leading indicator of stock market returns by recognizing that the relationship is positive (negative) for bad (good) economic conditions.
