by Kevin Klombies, Senior Analyst

Tuesday, January 8, 2008

Chart Presentation: A New Year

After a very nice break from the markets it is time to get back to work. At the start of quarters and especially early in a new year money tends to shift in search of new ideas, themes, and trends so hopefully we will have something interesting to follow over the next few weeks.

The chart at right compares the stock price of Merrill Lynch (MER) and crude oil futures. This is one of the most basic relationships on the go at present.

The argument is that energy price strength is going with weakness in the financials. If crude oil futures prices remain below 100- and the markets made a very good attempt at breaking above that barrier during our absence- the financials could be making some form of bottom through January.

Another view is shown below right using the sum of copper and crude oil futures prices and the cross rate between the Japanese yen and the Canadian dollar futures (JPY/CAD).

The Canadian dollar trends with commodity prices while the Japanese yen tends to weaken against the CAD and Australian dollar when commodity prices are strong and rising.

Our point is that while traders did an admirable job of bidding commodity prices higher into year end the forex markets painted a much more subdued picture. The JPY/CAD cross rate tends to rise above its moving average lines as the sum of copper and crude oil comes down to its moving average line so early in the week it still appears as if energy and metals prices could collectively decline by close to 10% before support is reached.

The basic argument that we are trying to make is that there has been a very tight relationship between weakness in the major U.S. banks and brokers and strength in energy prices. On the other hand the U.S. dollar is holding reasonably well and there is just enough weakness in the Canadian and Australian dollars to suggest that the commodity trend could be coming to an end as we start the new year.



Equity/Bond Markets

At right is a comparison between the Canadian dollar (CAD) futures and crude oil futures from late 1996 into 1999.

Focusing on the two-year time period between the start of 1997 and the end of 1998 we wish to make three points. First, currency trends show the direction of the flow of money. Second, money moves towards growth. Third, crises tend to take place at the end of a trend.

The Cdn dollar and crude oil prices turned negative at the start of 1997 along with the Asian growth theme. The Asian crisis, however, did not hit the markets until the autumn of 1998 and then extended through Russia and Brazil into early 1999.

The argument is that capital flowed away from the Asian markets for almost two years before the markets moved into crisis and following the standard central bank response of easier credit and lower interest rates one of the best performing asset classes through 1999 were the Asian equity markets.

Circling around the point- as usual- we show below right a comparison between Japan’s Mitsubishi UFJ (MTU), U.S. home builder DR Horton (DHI), and 3-month euroyen futures. At 99.9 euroyen futures represent a yield of .1% while at 99.1 the yield would be .9%.

In early 2006 short-term Japanese interest rates began to rise while the U.S. dollar declined. The biotechs as well as the Japanese banks turned lower along with the U.S. home builders.

Close to two years ago capital began to leave the financials, home builders, biotechs, and especially the dollar in search of better growth opportunities. Similar to 1998 this eventually lead to a financial markets crisis with the focus of the weakness showing up in the regions which had experienced declining currencies due to capital outflows. Concurrent with this the equity markets began to rotate back towards large-cap U.S. consumer stocks such as Coca Cola (KO)- shown below.

If crude oil prices remain below 100 then, as we showed on page 1, we can make the case that the financials should start to recover. Our argument here is that the sense of crisis that pervaded the markets through the second half of 2007 was the result of close to 2-years of capital outflows similar in many respects to the pre-Asian crisis markets during 1997- 1998.