by Kevin Klombies, Senior Analyst

Thursday, January 17, 2008

Chart Presentation: 1995

We are going to start things off today by taking a walk back in time. Since we have been focusing on the apparent peak in ocean shipping rates (Baltic Freight (Dry) Index) along with the positive ramifications for the U.S. dollar we thought this might be an appropriate time to show how the markets reacted the last time shipping rates reached a cycle peak. For that we have to return to 1995.

The chart above right compares the CRB Index, the U.S. Dollar Index (DXY) futures, and the Baltic Freight Index (BFI). The BFI is now properly called the Baltic Dry Index but our purposes here we will stick with the older name. The BFI is an index of freight rates for dry bulk cargo over 11 major shipping routes so it represents ‘real’ economic activity as opposed, we would argue, to the financial and commodity futures markets most days.

In any event in the spring of 1995 the BFI reached a peak at the same time the dollar hit bottom. In this instance the break down in ocean freight rates associated with a slow down in global trade preceded the peak in the CRB Index by close to a year, the Asian crisis by more than three years, and the next serious U.S. equity bear market by over five years. In other words a slow down in economic activity associated with global trade has much to say about the trend for the dollar and very little of importance to add to the arguments surrounding the absolute levels of equity and commodity prices.

We use the term ‘absolute’ for a reason because the argument goes on to include changes in the trend between ‘relative’ prices. To show this we have included a chart of the ratio between the S&P 500 Index (SPX) and DJ AIG Commodity Index (DJCI) at right along with the stock price of drug maker Schering Plough (SGP).

Perhaps the most dominant trend coming out of early 1995 was the rise in the equity/commodity ratio. Interest rates began to decline in early 1995 followed by dollar strength in the summer and as money began to push back towards the U.S. the consumer, health care, and financial sectors began to outperform. Between 1995 and the bull market peak in 2000 the equity/commodity ratio moved upwards as pharma names such as SGP and Merck along with consumer names like Coke and Pepsi pushed higher. By the end of 1996 crude oil prices turned lower which helped to propel the major U.S. autos and airlines higher along with retailer Wal Mart.


Equity/Bond Markets

In yesterday’s issue we showed that the sum or combination of copper (in cents) and crude oil (in dollars multiplied by three times) futures prices tends to mirror the sum of combination of long-term Treasury prices (30-year T-Bond futures) and the dollar (U.S. Dollar Index- DXY). We commented that on two prior occasions- 1990 and 1995- the bond market and dollar bottomed at the peak for metals and energy prices and on both occasions this led into a very positive equity market. We could also have used 1987 as a third example but for the fact that exchange trading in copper futures did not begin until 1988.

In any event the point was that recent trend has been somewhat unique in that copper plus crude oil made two peaks concurrent with two bottoms for the TBonds and dollar.

Our argument has been that this can be explained by the emergence of the ECB as a major player in global monetary policy. In times past when the Fed shifted to easier or tighter monetary policy it would set up a chain reaction that would work through the various markets eventually impacting commodity prices about two years later. In other words the start of rising U.S. interest rates (declining 3-month eurodollar futures prices- chart below right) in the spring of 2004 was expected to turn commodity prices lower no later than the spring of 2006. What ended up happening- we suspect- is that the second top for commodity prices is related to the start of rising European interest rates during the fourth quarter of 2005.

The point? From now through into at least mid year or even well into 2009 the commodity markets are going to be negative. Period.

Below is a chart comparison between the S&P 500 Index (SPX) and the cross rate between the euro and the yen. The euro/yen cross has been rising as money has moved away from Japan to take advantage of higher yields abroad along with stronger growth momentum. Obviously the cross rate is a virtual mirror image of the U.S. equity markets but, strangely enough, we expect these very similar trends to eventual diverge. It does make for an interesting chart picture, however.