As a trader you are constantly on the lookout for new correlations and variables that can predict the direction of stock prices effectively. While volumes, charts, momentum, earnings are all very common measures, one way to look at equities is through the linkage to commodity prices. What do we understand by commodities? In financial parlance, commodities are those minerals and ores that are extracted from the ground. Thus copper, zinc, iron ore, gold and even crude oil are all examples of some of the most powerful commodities in the global market. So what exactly is unique about commodities as an asset class?

• How commodities are unique?

Commodities are unique in a variety of ways; in terms of their demand/ supply dynamics and their pricing. Firstly, most commodities are very sensitive to demand and supply factors. Thus new mines being commissioned or new applications for the commodity can have large scale implications for commodity demand and supply. Secondly, commodities do not rely on any brand value factors. Hence prices of these commodities are largely dependent on the factors of demand and supply. Prices are stable as long as demand and supply are matched. The moment either the demand starts shifting or supply starts shifting, there is a visible impact in price. We saw this phenomenon in the crash in oil prices post November 2014. Thirdly, commodity markets are huge globally and there are speculators, traders and hedgers constantly interacting in this market.

• How commodity trends provide equity trading cues..

Commodity prices impact the price of equity in two unique ways. Firstly, there are companies that are purely commodity companies. Companies that produce aluminium, iron ore, copper, and zinc are all examples of commodity driven companies. Similarly, oil extractors and gold mines are also examples of commodity producers. These companies are referred to as output-sensitive stocks where their business performance is directly dependent on the price of the commodity. These companies tend to do well when the commodity price is on an upswing. The second sets of companies where equities are impacted by commodity prices are known as input-sensitive stocks. These companies are into businesses which use commodities as inputs. For example the paint industry uses oil as an important input and the performance of these companies tend to outperform when the price of the commodity input is on a downswing.

The upswing story: Copper prices and Vedanta stock price (Last 1 Year)..
To understand the story we have plotted the copper prices on the LME with the stock price of Vedanta. Remember, Vedanta is a global commodities conglomerate with exposure to zinc, aluminium, copper and even crude oil. Copper continues to be a major chunk of Vedanta’s performance. The chart below tracks the performance of Vedanta on the NSE with the price of copper on the LME.

 

The chart above clearly depicts a direct and almost proportional relationship between the global copper price and the stock price of Vedanta. While copper prices are up nearly 40% in the last 1 year, the stock of Vedanta is up by 55%. Copper prices are up due to a sharp revival in Chinese growth and expectations of a construction boom in the US once Trump implements his massive $1 trillion infrastructure plan.

The downswing story: Crude oil versus Asian Paints (Last 5 Years)

Having seen the output story playing out let also look at the input story play out with respect to crude oil. Consider the chart below..

 

To get a better perspective of the downswing story we have plotted the price of crude oil in the Brent market with the stock price of Asian Paints. There is a clear negative relationship between the two. For example, during the 5 year period, the price of Brent crude is down by (-44%) while the price of Asian Paints is up by 200%. If you look at the chart closely, both these graphs are almost parallel till late 2014 when the oil price crash started. The entire divergence in performance has come after that. This is a clear example of Asian Paints benefitting substantially from a sharp fall in crude oil prices leading to lower input costs.

 

• How do you as an investor use these relationships?That is the bottom-line. Get a commodity price screen and a stock price screen on your trading platform. That is not too complicated. In most of these cases, a very short term view may be misleading and may at best give you short term trading signals. But when there is a clear long-term trend visible like; oil post 2014 or metals in 2017, you can clearly take equity positions and ride on the trend. You need to understand whether you are playing the output impact and hence the upswing or the input impact and hence the downswing. Either ways; it is a fairly simple and foolproof method of playing the markets. Of course, the risk is entirely yours!

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