by Kevin Klombies, Senior Analyst

Tuesday, April 22, 2008

Chart Presentation: 2000 Comparison

We tend to believe that history repeats which explains why we typically show the current markets cycle in relation to some past time period. The problem is that no two markets cycles are ever identical so it often takes some combination of effort and imagination to put things into some form of perspective.

We are going to return to an argument that we made a couple of times a few months back. The premise was that the relentless rise in crude oil futures prices was somewhat similar to that of the Nasdaq from late 1998 into 2000.

At top right we show the Nasdaq 100 Index (NDX) and the yield index for 10-year U.S. Treasuries (TNX). The start of the rally in the tech and telecom sectors following the Asian crisis in 1998 went directly with rising long-term Treasury yields.

The chart detail that intrigues us has to do with the fact that the TNX peaked and turned lower a couple of months before the Nasdaq reached its high. At the time this made absolute no sense but with the benefit of hind sight we know that the pivot in the direction of interest rates was the markets’ way of telling us that the capital spending cycle was losing momentum.

The point is that yields and the Nasdaq were rising in tandem but about two months before the Nasdaq reached a cycle peak interest rates began to decline.

At bottom right we show crude oil futures and the TNX. Once again there is a relationship between a major cyclical market- in this case oil prices- and the direction of long-term yields. However, the relationship is almost exactly the inverse of 1998- 2000 as strong oil prices have gone with declining instead of rising yields.

Our argument is that regardless of whether crude oil prices continue to rise for another week, month, or even into June the key to the future rests with the bond market. If 10-year yields continue to rise then the bond market is letting us know that something important has changed and that in due course this will show up in weaker crude oil prices. If crude oil futures follow the same basic path as the Nasdaq then some time late in 2009 we could see crude back to roughly the 50 level.



Equity/Bond Markets

We are going to take another run at a chart comparison that we showed in yesterday’s issue. Our sense is that this will eventually help lead us out of the current markets morass.

The chart is based in large part on a comparison from 1990. The bottom for the U.S. equity markets was made at the peak for crude oil prices in October of 1990 and as the stock price of Wells Fargo (WFC) pushed back above its 200-day e.m.a. line crude oil prices AND the ratio of the oils (XOI) to the SPX moved below their respective moving average lines.

The point was that the oils were strong into the equity markets bottom and then the equity markets resolved higher as oil prices weakened. The leaders into the bottom were the oils but after the pivot this sector actually underperformed the broad market until the spring of 1999.

The chart compares WFC and Carnival Cruise Lines (CCL) with the ratio between the XOI and the SPX. The premise is that when the oils finally begin to weaken the offset will be strength in the financials (WFC) and the energy-consuming cyclicals (CCL). In other words when WFC and CCL finally break back above their moving average lines the markets should be some distance into a trend change.

Both WFC and CCL challenged their moving average lines at the end of January as crude oil prices tested back to the 86- 87 level. From there crude oil prices reversed higher pushing up to 110 before declining once again to 100 as WFC and CCL lifted higher. Once again crude oil prices began to strengthen to the point where they were just below 118 in late trading on Monday.

We have no idea- none actually- how many times the markets are going to work through this circle. Weakness in crude oil prices helps lift the share prices of WFC and CCL but as they approach resistance oil prices swing to new highs. A decision point was reached last August when crude oil prices declined to 70, again in January at 86, and a third time in March around 100. Our point, however, is that there will come a time when oil prices will weaken, the equity prices of stocks such as WFC and CCL will return to their moving average lines and… oil prices will continue to decline as these share resolve higher. In a perfect world that will mark the change in trend that will go with at least a few years of flat to lower energy prices.

Each time the European Central Bank states that it is worried about inflation the markets send the euro higher but as we have pointed out in the past this is actually a negative for European equities.

The chart at bottom right compares the euro futures with the ratio between France’s CAC 40 Indice and the S&P 500 Index.

The point is that when the euro made new highs above 1.37 last summer the CAC/SPX ratio was around 4:1. As the euro has driven higher against the dollar the ratio has worked lower to its present level around 3.55:1.

In a sense this chart helps to explain why the markets tend to move in cycles instead of straight lines. The weaker U.S. economy goes with a falling dollar which, in turn, helps adjust the terms of trade so as to make U.S. exports cheaper.