In April and May of 1987 the SPX made two bottoms. The first was related to the ‘crossing’ of the moving average lines (i.e. ‘1’) by the TBonds futures while the second was associated with the absolute low made by the bond market a few weeks later (i.e. ‘2’).

The silk purse that we keep referring to relates to what the SPX did in between ‘2’ and ‘3’. From the lows for the bond market in May of 1987 up to the break down through those lows three months later in late August the SPX rose by roughly 20%.

Now... do we expect the SPX to rally 20% over the next few months? Probably not but that isn’t the point. Our view is that the SPX is under pressure as the euro declines in a manner similar to the way the SPX was pulled lower with the bond market between late March and April of 1987.

Our thesis rests on the following foundation:

1) The euro is declining as capital moves away from the Euro-zone. Following close to a decade of currency strength against the dollar, yen, and Chinese renminbi cracks are beginning to appear in the economic health of countries like Greece, Spain, and Portugal.

2) A change in the direction of the flow of capital tends to usher in the start of a new trend.

3) At present the equity and commodity markets are declining in response to euro weakness.

4) There are (at least) two potential outcomes. First, the euro finds support as it did in late 2008 and early 2009 and the markets swing back to the old trend. The ‘old trend’ includes relative strength in the cyclical sectors with an emphasis on commodities. Second, the euro is in the early stages of a correction that could run for years. If this proves to be the case then the U.S. equity markets should shift relative strength over to the consumer stocks (Wal Mart, Coke, Pepsi, Proctor and Gamble, Merck, Pfizer, CVX, etc.)

One of the keys for the markets through 2008 was that as soon as the U.S. dollar began to rise- putting pressure on the commodity markets- both consumer and producer stocks declined (although the consumer names outperformed simply by not falling as far or as fast).

So... if the sectors that tend to do well with a stronger dollar (tech and consumer growth) are unable to support the equity market then we end up with a situation where the equity market is virtually at the mercy of the euro. The argument was that the euro has fallen to the point where the moving average lines are set to cross- an event that has the potential to mark a correction bottom.

The comparison to the bond and equity markets from 1987 suggests that once the euro stabilizes we could see a return to equity markets strength until such time as the euro is ready to break to new lows once again.

Below is our comparison between the S&P 500 Index (SPX), the spread or difference between 2 times the share price of Suncor (SU) and crude oil futures, and the cross rate between the yen and the euro.

On Friday crude oil futures prices closed down 1.95 to 71.19 while the share price of Suncor rose .28 to 29.80. Weaker crude oil prices combined with an increase in the share price of SU narrowed the spread into the -11’s.

On Friday the yen/euro cross rate rose to yet another intermediate-term peak. This cross rate tends to trend with or lead the U.S. dollar.

The point? We have been arguing for months that in order to create some kind of intermediate-term bottom for the equity markets two factors have to click into place. First, the yen/euro cross rate has to make some kind of peak. Today’s issue was filled with conjecture and speculation with regard to an impending low for the euro.

Second, the share prices of the oil stocks (Suncor) have to stop being weaker than crude oil prices. Our ongoing argument is that crude oil prices tend to be drawn towards roughly double the price of Suncor (59.60). If SU were to fall from 29.80 down to, say, 20 then the equity markets would be pressuring crude oil prices down into the 40- 50 range.

How to explain? Let’s say Suncor holds at 30 while crude oil prices rise back to 75. This would be bearish. Why? Because the share prices of the energy ‘producers’ aren’t rising even as rising energy prices put pressure on the energy ‘users’.

Let’s say Suncor holds at 30 while crude oil prices decline to 65. This would be bullish. Why? Because the energy ‘producers’ aren’t declining even as falling energy prices work to increase the profitability of the energy ‘users’.

In any event... the spread between Suncor and crude oil prices improved at the end of last week and this was somewhat encouraging. If the spread continues to work higher then all we really need is a peak in the yen/euro cross rate to mark the start of a recovery for the SPX. Hence... our fixation today on the chart of the euro futures.

Below is a chart of the ratio between the Amex Oil Index (XOI) and S&P 500 Index (SPX).

Last Friday the XOI/SPX ratio finally broke to new lows.

We have argued that a broad recovery for the SPX should go with a declining ratio. We have argued that one of the problems facing the recovery since late summer of last year has been the lack of ‘new lows’ for this ratio.

Our view was that a number of large cap ‘big names’ were being held below the highs set since the last bottom in the XOI/SPX ratio. General Electric, Cisco, Intel, Wells Fargo come to mind as examples. Our hope was that when energy prices weakened to the point where the XOI/SPX ratio fell to new lows the equity markets would be ready to return to a more bullish trend. On page 4 we show a comparative view between the XOI/SPX ratio and the share prices of Wells Fargo and Carnival. Our focus is on the way these share prices began to rise in early July of last year after the XOI/SPX ratio broke below previous bottom set in April.