Today could be an interesting day in the markets. The 2-day Federal Open Market Committee meeting concludes, we get the weekly energy inventory report, and the day will be full of quarterly earnings reports starting with Wells Fargo ahead of the opening and ending with Boston Scientific after the close. In a world where portfolios managers seem to be universally long the major oils and short the banks almost anything could happen as a result.
We spent a few weeks building a thesis that argued that we would have to wade through one more bout of cyclical weakness into mid-year before the equity markets could turn sustainably higher. We then covered our… bets… by arguing that the markets went through the process of making A cyclical bottom through the fourth quarter of 2008. The only way that we could possibly rationalize the two somewhat opposing views is to fall back on the notion that ‘financial’ leads ‘real’.
The argument would be that the markets move through a rotation or progression that begins with falling interest rates and upward pressure on financial prices and leads- eventually- into stronger real prices. In other words the stock market should rise in advance of commodity prices and not the other way around. Copper prices, for example, should not drive mining shares higher because mining shares should anticipate future strength for base metals prices.
In any event we have included a comparative of view of two ratios below. The chart compares the ratio between the S&P 500 Index (equities) and U.S. 30-year T-Bond futures (bonds) with the ratio between Japan’s Mitsubishi UFJ (MTU) and the gold etf (GLD).
The argument is that if the markets have made a reasonably significant cyclical bottom then both of these ratios should turn higher. The equity market should rise relative to the bond market while the share prices of the major financials should do better than gold.
In this perspective gold and the TBonds are destinations for ‘risk averse’ capital as it drains away generally from the equity market and more specifically from the major banks. If this is indeed a cyclical bottom- a somewhat shaky contention to be sure- then both ratios should resolve upwards. We are not arguing that bonds and gold have to decline but rather that the equity markets and banks have to do better. That is why we are particularly interested in how the markets react today to Wells Fargo’s numbers.
Jan. 27 (Bloomberg) – Copper prices plunged, heading for the largest drop in almost eight weeks, as the slumping global economy slashed metal demand and led to surging warehouse inventories.
Copper stockpiles in storage facilities monitored by the London Metal Exchange jumped 2.8 percent today to 451,800 metric tons, the most in five years. Since June 30, supplies have more than tripled, helping to drive prices down by 61 percent.
Our page 1 point was that copper prices should not lead the mining sector higher but the mining sector could lead base metals prices higher. On the other hand the relative strength in copper- compared to crude oil- has been one of the negative ‘drivers’ behind weakness in the share prices of stocks such as Wal Mart.
We are going to do this one last time and then tuck the chart into the back pages until something changes. The argument for the chart below was that the rising trend for the copper minus crude oil spread (copper in cents minus three times the price of crude oil in dollars) was acting as an offset to downward pressure on stocks such as WMT. Copper futures prices were weaker yesterday but were still better than front month crude oil futures which fell close to 4 dollars yesterday.
The bottom line or, we suppose, the point that we are stretching towards is that copper is still somewhat stronger than crude oil but since trends often change in the first month of a quarter it is conceivable that the bottom for the spread occurred in mid-July last year with the top being made in mid-January.
At bottom we show a chart of the yield index for 10-year U.S. Treasuries (TNX) and the ratio between Johnson and Johnson (JNJ) and the S&P 500 Index (SPX).
This is actually quite an interesting chart.
The first point is that when yields are falling the JNJ/SPX ratio tends to be rising. In other words when cyclical growth is weak enough to push interest rates lower money tends to gravitate towards defensive stocks like JNJ. Fair enough.
The second point is that THE PEAK for the JNJ/SPX ratio in 2002 lined up with the start of the equity market’s recovery. In other words when the JNJ/SPX ratio rose to just below .075 the stock market turned higher which pushed the ratio lower once again.
The third point is that bond yields continued to decline for another 9 months. The JNJ/SPX ratio peaked in October while the TNX bottomed the following June.
The next point would be that we have argued that the markets worked through A bottom last quarter and this bottom lined up with the JNJ/SPX ratio spiking up to just below .075 once again.
The bottom line is that while we still think that JNJ can rise towards 75- 80 simply because it is ‘low’ relative to the TBond futures if we have reached THE cyclical bottom then the ratio should not make new highs. If the share price of JNJ continues to rise faster than the broad market so that the ratio breaks above the peak set last November then we will argue that clearly the equity markets have not made a cyclical low. Similar to the page 1 charts which show the potential for a bottom in the SPX/TBond futures and MTU/GLD ratio this is an example of a very tight relationship that has yet to make a clear statement about the state of the current cyclical trend.