by Kevin Klombies, Senior Analyst

Thursday, April 17, 2008

Chart Presentation: All Things China

Some time around the start of the new millennium we wrote that we expected this decade to be about ‘all things China’ which, for a change, actually turned out to be rather prescient. At the time our view was that the markets would be dominated by the health of China’s economy.

Our point is that this cuts both ways. During periods of rapid expansion Chinese demand can most certainly impact commodity prices but if China ever falters then commodity prices will very likely decline at a much faster pace then they rose.

A few months or quarters from now we will find out whether the U.S. economy is or has been in recession so it rarely makes sense to put positions on based on government statistics. The equity markets, on the other hand, tend to lead the economy so instead of thinking that stocks must go down because the economy is weak it usually makes more sense to conclude that the economy must be weak because stocks are going lower.

At top right we show the Shanghai SE Composite Index and the stock price of Wal Mart (WMT).

As mentioned here yesterday one of our ongoing arguments has been that WMT is trending inversely to China’s equity market so as it breaks to new highs our conclusion is that downward pressure on Chinese shares continues.

After the rollicking equity trading session in North America yesterday we would be surprised to see the Shanghai Comp. breaking support over night but, then again, the markets have been known to do surprising things. The chart below right compares the Shanghai Comp. with copper futures.

As Wal Mart has risen the Shanghai Comp. has declined and, as mentioned above, a falling stock market tends to forecast slower economic growth. In fact the Chinese equity market has been trending lower for close to 6 months so the short-term argument would be that if the Shanghai Comp. breaks down through 3200 then the pressure on base metals prices will increase. If recent history is any guide what so ever then a few trading days later we would expect to see copper prices moving back below the 3.80 level.



Equity/Bond Markets

Our working premise this week has been that we have to get the earnings releases from financial heavyweights like JP Morgan Chase and Citigroup out of the way before the markets will get busy setting a new trend of accelerating back to the old one. We could probably have tossed in Merrill Lynch as well. MER reports today with C due on Friday.

At the end of trading on Wednesday we had two basic thoughts. The first was that the crude oil futures market is ‘nuts’ and the second was that very shortly something is going to explode.

Oil prices continued to rise yesterday following a surprising decline in U.S. oil inventories. To us this really doesn’t make much in the way of sense because inventories declined in the first place because crude oil prices have been so strong.

Our point is that according to the EIA a year ago in the week ending April 13, 2007 the U.S. imported an average of just over 9.9 million barrels a day of crude oil while in the week ending April 11, 2008 the daily average was just under 8.9 million barrels. In other words imports were close to 1 million barrels per day lower which goes a long way to explaining the ‘surprising’ decline in inventories. If rising oil futures prices continue to reduce imports as refiners run down current inventories while global oil production remains constant then somewhere between the Persian Gulf and the U.S. inventories of unsold will be building.

In any event at top right we show the S&P 500 Index and the CBOE Volatility Index (VIX).

The argument here is that following the release of earnings from JPM and some good numbers from companies such as Coke and Intel (not to mention IBM after the close of trading) the VIX declined. In theory it may well have ‘broken down’ although it has bottomed below its 200-day e.m.a. line on a number of occasions recently.

In October, December, and as recently as early April tests below the 200-day e.m.a. line for the VIX have gone with peaks in the equity markets. In other words each time the volatility declined to current levels the equity markets began to collapse which served to lower interest rates and raise volatility.

Yesterday longer-term Treasury yields moved higher along with the equity markets so our thought was that either the trend is changing or the equity and/or commodity markets are going to do something spectacular ahead of the next Fed meeting on April 30th. We will try to circle back to this point as best we can on page 3 and 5.

At bottom right we show the CRB Index and the ratio of the pharma etf (PPH) to the share price of Caterpillar (CAT).

The PPH/CAT ratio bottoms at the peak for commodity prices and peaks at the bottom for commodity prices. The ratio has generally been moving lower since January of 2007.

To a large extent the strength in the equity markets is still coming from rising commodity prices which is all well and fine except that it tends to create rather brisk but short stock market rallies.