Trouble brewing? The pointers for a stock market crash and recession

“Sell in May, come back in on St Ledger's Day” is the traditional behaviour of stockbrokers in London – close off your positions for the summer, head for the Med and worry about the market when you get back.

It's not as closely observed as it might once have been, but for those who did sell in May, it's nearly time to come back – St Ledger's Day is on Saturday, September 16.

What are they coming back to? Turns out the absentees have missed a lot of action; much of it could spell trouble on their return.

The central banks weren't finished with interest rises in May – rates went up at least twice in the US, the eurozone and the UK. Inflation started to come down but remained “stickily” high in Britain.

Alarm bells began ringing as the US Treasury's inverted yield curve worsened in June. A yield curve inverts when short-term bonds are paying higher interest rates than long-term bonds.

In 2006, yield curves were inverted for much of the year. Long-term Treasuries then outperformed shares in 2007. The year that followed was the stock market crash of 2008 and the start of what became known as the Great Recession.

It's not something that makes headlines every day, but in early July, when the deepest inversion since 1981 occurred, it caused a stir.

That's because inverted yield curves can point towards recessions, and this particular inversion has “been screaming recession for over a year now”, Russ Mould, investment director at AJ Bell, told The National.

Some big names in the investing world made some gloomy statements about the stock markets over the summer.

Citigroup predicted the S&P 500 would lose around 10 per cent of its value by the end of the year. Well-known Wall Street bearish voices, including Mike Wilson from Morgan Stanley and Marko Kolanvovic from JP Morgan Chase, reiterated their downbeat forecasts during July.

Share markets have done well so far this year, especially in the US. The Dow Jones Industrial Average is 4 per cent higher, while the Nasdaq has put on nearly 30 per cent.

The British billionaire investor Jeremy Grantham, who cofounded of investment management company GMO, believes bubbles are building and the likelihood of a crash is about 70 per cent.

Michael Burry, the man who made $100 million on short positions in the run-up to the 2008 subprime financial crisis, recently made a similar $1.6 billion bet against the S&P 500 and the Nasdaq in the US.

It's thought Mr Burry, who was Christian Bale portrayed in the film, The Big Short, is staking more than 90 per cent of his hedge fund’s portfolio on his prediction of a crash before the end of the year.

Metal moves

While the drama and speculation make for good headlines, analysts use many different mathematical tools to calculate possible market movements and the fortunes of economies.

The copper-gold ratio is one such tool.

As the copper-gold ratio employs the prices of two metals with very different uses, economists and market strategists use it as an indicator of possible future recessions.

Copper is an industrial metal and serves as an indicator of global economic health. Its widespread use in construction, infrastructure and technology means that if there's a strong demand for copper, economies should be growing. Indeed, copper is often referred to as “Dr Copper” because of its ability to signify the well-being of economies.

Gold, on the other hand, is traditionally a store of value during troubled times. It's a safe haven investment that has limited use in industry. If the value of other assets is eroded by rising inflation or debt, investors are always tempted to go for gold.

As such, the relationship between the prices of copper and gold becomes an important tool for traders and a device for economists attempting to predict future economic fortunes.

“A study of the copper-to-gold ratio could therefore be informative,” said Russ Mould, investment director at AJ Bell.

“If copper does better, this may be the markets’ way of saying that the good times might be ready to keep rolling.

“If the precious metal outperforms the industrial one, that could be an indicator that something bad is going to happen – an inflationary outbreak or a recession [or even both at the same time, in the worst of all worlds, and a return to the stagflation of the 1970s].”

So, as the price of gold rises and that of copper falls, the copper-gold ratio declines and vice versa.

If the price of copper rises and the price of gold plunges, the ratio will move well above one standard deviation from the 30-year average, denoting a growing economy. In reverse, it can point to a recession.

“I think it is useful to gauge economic momentum, that is when the ratio is rising, it is generally associated with rising economic activity since copper is a proxy for industrial commodity demand,” Janet Mui, head of market analysis at RBC Brewin Dolphin, told The National.

“Plotting against other indicators, it can be useful in seeing whether there is divergence/deviation between the ratio and other market indicators, such as bond yields.”

However, market strategists and economists have many tools when it comes to analysis. The copper-gold ratio is just one. Its usefulness waxes and wanes in relation to other indicators and specific developments.

“Nothing's going to be perfect, right?” Mr Mould told The National. “Because if it was that easy, we'd all be sat at home or on the beach, wouldn't we?

“People are always looking for this sort of pointer, and previously reliable mechanisms like an inverted US yield curve, which has been screaming recession for well over a year, currently aren't working.

“But we all have to bend ultimately to the adage that the past is no currency for the future, but it generally has been in the past as a reliable indicator.”

Ms Mui agrees that, as will all analytical tools, the copper-gold ratio is not a perfect predictor of recessions.

“For example, the ratio was above 10 when the 2008 recession started,” she told The National.

“There have been several occasions when the ratio fell below one standard deviation of the 30-year average, but there was no recession.”

China worries

Also, copper prices can be quite volatile as demand can be both structural and cyclical. China's quest to build more cities in recent decades has been one of the main pillars of copper price support, but that looked somewhat shaky given a deflating bubble in the country's property sector.

Recent analysis from S&P shows that more than 50 Chinese property development firms have defaulted on their debts in the last three years.

However, the energy transition to net zero is sparking up new demand for the metal as the production of electric cars provides just one example of the use of copper in a post-fossil fuel world.

The energy transition was a large factor when Europe's largest copper producer, Aurubis, restated a strong profit forecast this year after posting a 20 per cent rise in quarterly earnings last week.

This has created a debate in the market over which way the copper price will move next.

Golden future?

Gold prices are also struggling to find direction at the moment. The precious metal had a solid first half, rising by 5.4 per cent.

But if, as some predict, the world's major central banks switch from tightening monetary policy to keeping interest rates on hold, the upside to gold prices may be limited.

“Despite signs of cooling inflation, the combination of stock market volatility and ‘event risk’ [such as geopolitical or financial crisis] is likely to keep hedging strategies, including gold, in place,” the World Gold Council said recently.

If nothing else, the copper-gold ratio illustrates the risk of relying on one particular indicator as a forecaster of future events.

Starting blocks or precipice?

However, there is some consensus that it may be an eventful Autumn. There are conflicting views on which direction events and metrics will take markets and economies.

Kevin O'Leary, the Canadian businessman and star of the TV show Shark Tank, feels Michael Burry's bet against the S&P 500 and the Nasdaq is “very risky”.

Many economists still see a soft landing for the US economy as a distinct possibility, given that many indicators are pointing that way. The Federal Reserve also appears close to the peak of its tightening cycle.

Nonetheless, because interest rate rises take between six to 18 months to take effect, exactly how much the US economy will be affected by several interest rate rises remains to be seen.

Back in May, a survey of investment firms by Bloomberg put a target level of 4,000 on the S&P 500 by the end of the year. That's now been raised to 4,300.

For Mr Mould at AJ Bell, there are risks – US equities look overvalued. Due to their sheer size and clout, the handful of big tech shares – known as the Magnificent Seven (Microsoft, Apple, Amazon, Google parent Alphabet, Tesla, Nvidia and Meta) – exert significant influence over market indices.

“I think those things do naturally make you nervous, but they've made me nervous a year ago and a year before that,” he told The National.

“Ultimately, you rely on the old saying that if something can't go on forever, it will eventually stop, but nobody knows when.”