Earlier this year we argued that based on the peak in long-term bond prices and subsequent push to higher Treasury yields the markets were ‘saying’ that cyclical growth was beginning to improve. We then argued that the base trend for the S&P 500 Index turned positive back in November of 2008 even as stock prices continued to decline.

We subsequently put together a number of comparisons to make the case that the SPX should pivot back to the upside in March and rally for almost exactly two months. Based on past lags between bond market price peaks and stock market bottoms it appeared that an early March pivot was due. So far, so good.

The SPX made bottom in early March and began to rise until it approached the 200-day e.m.a. line two months later in early May. Once again… so far, so good.

The chartbelow compares the SPX with the U.S. Dollar Index (DXY) futures.

The next stage of the thesis was that prices would consolidate from early May into early August and this is turning out to be almost as stressful as the call for a market bottom back in March. On the one hand the chart shows that the SPX has yet to move above the peak set earlier this month while on the other hand the sheer ferocity of the cyclical recovery makes it almost impossible to be bearish.

We are showing the equity market and the dollar together for a reason. The idea is that the ‘driver’ behind the rising stock market is a weaker dollar so if the stock market is going to pause or flatten out through into June we would expect that it will do so because the dollar is starting to firm. In other words if the offset to rising stock prices is a falling dollar and a falling dollar is helping to create upward pressure on commodity prices then risk begins to build in the cyclical asset price sectors if the dollar shows any inclination to pivot back up through 83.

When a market is in a strong and rising trend but gets temporarily pushed down below its moving average lines the tendency is for prices to snap back above the lines before they ‘cross’. If the dollar actually proves to be in a positive trend then it will not spend much in the way of time below the 83 level. From an intermarket perspective this kind of dollar strength could easily serve to flatten out the equity markets through the summer.

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Equity/Bond Markets

A few years ago we formed the argument that the markets were running the ‘energy’ trend through the first six months of the year before switching to ‘something else’ for the second half of the year. Given that we are at the end of May we thought we should run through this once again.

Belowwe compare the chart of oil refiner Valero (VLO) from 2007 with a chart of Arch Coal (ACI) from 2008.

The energy trend is fairly broad. It includes everything from the oil and gas producers to the oil refiners, oil service companies, coal producers, and even the uranium stocks. From year to year the cycle will focus on one or more of these sectors.

The charts show that Valero represented the energy theme nicely in 2007 while in 2008 the focus was more on the natural gas and coal stocks. Notice that the trends began in January and did not stop until the end of the second quarter.

As mentioned the second half of the year has been dominated by non-energy themes. These themes also change from year to year but can and have included the airlines (as well as gold).

Below we show a chart of AMR from May of 2008 to the present day. Notice how AMR bottomed in July of 2008 just after the share price of Arch Coal turned lower. While it was anything but a smooth flight the share price of AMR managed to double from the July lows through to the early January 2009 highs at which time the markets shifted back to an energy theme once again leading to a price collapse for AMR.

Belowwe show the comparison between the ratios of crude oil to natural gas futures and gasoline to heating oil futures.

We have argued in these pages that the crude oil/natural gas ratio represents foreign vs. domestic growth while the gasoline/heating oil ratio tends to reflect consumer vs. industrial growth. The trend through the first five months of the year has been biased towards ‘foreign’ and ‘consumer’.

Our point? We may still be 4 to 6 weeks early on this but as we approach mid-year we expect the trend to finally shift away from the energy theme and on to something else. If interest rates continue to rise the ‘something else’ will likely be more cyclical (tech, airlines, etc.) while if interest rates start to decline we would look for better action in the consumer defensive and health care sectors.

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