We are going to start things off today with a bit of a macro perspective that has little to do with what is going on at present in the markets. This is the sort of thing that might prove useful at some later date.
On any given day one will read that the oil stocks were higher because energy prices had risen or, perhaps, that the basic materials stocks were down because base metals prices were lower. This creates the impression that the equity markets react to or follow the commodities markets. Our view is that the relationship actually works the other way around with stocks leading and commodity prices following.
At top right is a chart essentially from 2000 through 2006 of copper futures and the ratio between FreePort McMoRan (FCX) and copper.
A quick glance at the chart will show that the FCX/copper ratio ramped higher from the end of 2000 into late 2003 while copper prices remained generally flat. From 2003 into 2006 the price of copper pushed upwards as the FCX/copper ratio returned to almost its original starting point.
For three years FCX outperformed copper and then over the next three years copper outperformed FCX. In a sense the bull market in base metals prices represented a relative strength 'catch up' following the earlier strength in the mining stocks.
Below is a chart from 2005 into late 2008 of crude oil futures and the spread or difference between 2 times the share price of Suncor (SU) minus oil prices.
From 2005 into 2007 the share price of Suncor rose relative to crude oil prices. This created a similar situation in the energy markets to copper in late 2003. The oil stocks had trended higher in advance of the rally for crude oil.
Starting around the first half of 2007 the spread between Suncor and oil prices began to decline until by mid-2008 the severity of the negative correction argued that the stock market was pricing in much lower oil prices. Once again we can see the equity markets leading oil prices both to the upside and the down side.
The point? There is nothing- so far- in the trading of the mining and oil stocks that suggests imminent strength in the associated commodities.
We are going to touch on a topic that has been lurking in the shadows over the past few years. This is something that we believe we have not discussed so we might as well get on with it.
The premise is that a trend is created by an incentive but often one is better off doing the exact opposite. But... when?
Let's see if we can come up with an explanation for what we are attempting to get at here. At top right is a chart comparison between the S&P 500 Index and 3-month eurodollar futures from 1980- 83.
Lower eurodollar (or TBill) prices represent higher short-term interest rates. Between the end of 1980 and some time close to the middle of 1982 U.S. short-term yields chopped up repeatedly towards 17% (i.e. a price of 83).
The market was 'making' investors move into cash. Why buy a long-term bond with a lower yield or hold equities when cash paid 15% to 17%? The only logical thing that a rational investor could do is sell equities and move to cash. In response the S&P 500 Index declined into August of 1982.
So... the point is that the markets created an incentive to move from equities to cash by offering extremely higher returns and as one investor after another made the rational decision the stock market declined. Yet just ahead of the stock market's upside explosion the yield on eurodollars began to collapse. Those flexible enough to follow the markets piled back into equities- often at higher prices than their original sale points.
Below is the same comparison from 2008 to the present time period.
We have the exact opposite situation today. The rise in 3-month eurodollar futures prices towards 100 reflects the near-0% return being paid on cash. The markets are working hard to convince rational minds to move out of cash and into longer-term and riskier assets.
In response, of course, the S&P 500 Index is trending higher.
The issue that bothers us has to do with what the markets are forcing investors to do and the ability of most investors to react to significant changes.
In 1981 and 1982 it would have made sense to move to cash and then roll TBills until there is some indication that short-term yields were ready to decline. From there the ideal response would have been to go long equities. Yet the news of the day was so gloomy that this was not easily done.
In the current environment the best choice would have been to abandon cash when yields approached 0% and hold longer-term assets (bonds and stocks) until there is some indication that short-term yields are set to move higher. Every time we ponder this topic we come back to the fairly simple point that over time most investors would have been better off holding their stock positions through the 1981- 82 bear market instead of being driven into 'cash' and, if this is true, then will we discover in the months or years to come- as was the case in Japan post-1999- that even 0% in 'cash' is better than the riskier alternatives?