by Kevin Klombies, Senior Analyst

Thursday, July 26, 2007

Chart Presentation: 1990

The present market and the current economic situation are in many ways so unique that any comparison to previous time periods are limited in value. However… limited value rarely stops us from making the attempt.

In many ways today reminds us of 1990. The late 1980’s were marked by a speculative real estate market, rampant Asian growth, and through the wonder of junk bonds an excess of corporate take overs. It was a heady time indeed.

The U.S. equity markets slumped into a bear market in 1990 as interest rates and crude oil prices trended higher following Iraq’s invasion of Kuwait. The bottom for the equity markets was reached at the peak for oil prices and the bottom for bond prices in the autumn of 1990 and by the time the actual Gulf War began in January of 1991 the capital markets were well on the road to recovery.

The obvious question might be… when will the equity bear market begin? The answer is less than obvious and anything but simple.

We show a comparison between corn futures, the stock price of Bear Stearns (BSC), and crude oil futures from May of 1990 through April of 1991. We have included the same comparison for the current time frame below right.

The peak for corn futures prices in mid-1990 coincided with the start of serious equity markets weakness as shown by the decline in BSC. Both of these events served as the mirror image for the rising price of crude oil that helped to push interest rates upwards. When bond prices turned higher in the autumn concurrent with the top for oil prices both the equity markets and corn futures swung upwards.

Pondering when the equity ‘bear’ will begin is difficult because from this perspective it started months ago. The top for BSC and corn futures prices early in 2007 coincided with renewed price strength for crude oil. Our view that the Fed should cut the funds rate to help support the deteriorating real estate trend has been pushed well out in time because similar to 1990 we are in the midst of a furious oil price rally. In other words beneath the surface of what has largely been an equity market ‘bull’ we are seeing many prices decline in a most ‘bear-like’ fashion. It is strange to think that we might get to the end of the equity market’s correction- if oil prices ever stop rising- without ever being aware that a correction existed.



Equity/Bond Markets

To continue with the argument we have included below two charts of the ratio between the Amex Oil Index (XOI) and the S&P 500 Index (SPX) and crude oil futures. The chart below shows the time period from mid-1990 into early 1991 while the chart below right runs from late 2006 to the present day.

One key feature of the 1990 time frame was the sharp rise in the relative value of the oil stocks as crude oil prices moved upwards. This, of course, makes intuitive sense. The same situation has occurred this year as the broad equity market (SPX) has been supported in large part by the oils.

The chart compares U.S. 2-year T-Note futures with the product of crude oil futures times the Canadian dollar futures.

The idea here is that oil prices are ‘cyclical’ and when they are strong and rising bond price tend to decline. The Cdn dollar tends to trend with commodity prices so when it is rising it usually means that there is upward pressure on interest rates. When we combine the two by multiplying them together we get the inverse of the trend for the 2-year T-Notes.

The crude oil times CAD combination broke to new highs in early 2004 ahead of the start of Fed rate hikes. The combination peaked in mid-2006 which then marked the end of Fed rate hikes. The problem today is that each incremental rise in oil prices and each incremental decline in the U.S. dollar calls into question the notion that bond prices actually bottomed last year. The strength in energy prices this year has created a ‘bear market’ in quite a few sectors with the list growing almost daily. Our rather fervent hope is that the commodity trend will see fit to roll back to the down side before the markets find reason to drive Treasury prices down to new lows.