by Kevin Klombies, Senior Analyst

Wednesday, May 30, 2007

Chart Presentation: 1997 and the Hang Seng

NEW YORK, May 29 (Reuters) – U.S. blue-chip stocks fell on Tuesday and the Nasdaq composite index pared earlier gains as China said it raised a stamp duty on stock trades in Chinese markets and a sharp drop in oil prices hurt shares of energy companies…In the 16-year history of the modern Chinese stock market, an increase in stamp duty has always caused a market slump over the following few weeks or ended a bull run.

In yesterday’s issue we showed a chart comparison based on the ratio of the stock price of Caterpillar (CAT) to Coca Cola (KO). The argument was that in both 1988 and 2006 the ratio peaked with commodity prices with the equity markets- led in part by Asian growth- continuing to push higher for an extended period of time. There are certainly a number of similarities between the current time frame and 1989. We well recall the takeover frenzy inspired by Michael Milken, junk bonds, and LBO’s along with Dan Dorfman on CNBC detailing the takeover rumor of the day. Somehow that doesn’t seem that much different than the current private equity feeding frenzy.

Our sense is that, as always, this is going to end badly but the more important question is… when. Yesterday’s argument was that prices look higher into the autumn but we wanted to return to a chart-based argument that we have shown in the past just in case Asian equity price start sliding sooner rather than later.

The charts feature Hong Kong’s Hang Seng Index and crude oil futures. The top chart is from 1996 into early 1998 while below right we present the current time period.

The original argument was that similar to 1997 crude oil prices made a peak, declined into mid-1998, and then pivoted lower at the very start of the break/crash in the Hang Seng.

On the lower chart show have added a number of solid trend lines. The lines represent where crude oil prices would trend if the percentage decline into January and subsequent rally through April were identical to those of 1997. The idea was that if crude oil was following the same ‘path’ it would decline below 55, push back up to 66, and then turn lower on the way to 33. The caveat was that if today was something of a replay of 1997 then the Hang Seng should break rather sharply lower once energy prices finally began to roll over.



Equity/Bond Markets

The chart includes the U.S. 30-year T-Bond futures and the ratio between Caterpillar (CAT) and Coca Cola (KO).

It is fashionable and, perhaps, even rational to believe that interest rates are going to rise. We note for instance that PIMCO’s Bill Gross is now talking about the higher potential returns in emerging markets currencies and debt. Our problem is that we do not subscribe to the theory that commodity prices have begun a never ending bull rally that will last for years and years. Our view is that commodity prices had lagged all of the other major markets sectors and were going to rise to bring relative prices back in line. Our view is that this process ended last year.

The thesis is that the CAT/KO ratio goes with the commodity markets and is now in a declining trend. Obviously there is some doubt regarding both our thesis and our sanity given the recovery in the ratio from January into May but our point is that the TBond futures serve as the mirror image of the ratio. If the ratio is heading lower then bond prices should surprise to the upside. Of course two days in front of the monthly employment report during the strongest seasonal time of the year may not be the best time to think positive thoughts regarding bonds but as always we are thinking and writing ‘macro’.

We have done quite a bit of work on Fannie Mae (FNM) so we wanted to show the chart below right of FNM and the yield spread or difference between 10-year and 3-month Treasuries. The idea is that the intermarket ‘driver’ for FNM is the yield spread. If so then a rising bond market without falling short-term yields would turn the spread line lower along with FNM. Strange times indeed given that FNM typically trends with bond prices.

Below we once again feature the ratio between the oils and the broad U.S. equity market (XOI/SPX) and the CRB Index. The idea has been that a negative commodity trend has to be confirmed by weakness in the oils and while it might seem obvious that the CRB Index broke support yesterday… the XOI/SPX ratio is still very close to the highs.