Chart Presentation: Bulls and Bears

We mentioned in passing recently that an equity bull market begins with rising bond prices even though cyclical weakness may overwhelm or mask the positive trend for some time. We wanted to start things off today with a quick chart-based explanation of what this means.

At top right is a comparative chart of the U.S. 30-year T-Bond futures, the CRB Index, and the S&P 500 Index from 1981 into 1983.

There are two major ‘drivers’ for the equity market- valuation and cyclical growth. To the extent that equities are financial assets similar to bonds any trend that lifts bond prices will also lift equity prices. Commodity prices, on the other hand, tend to trend with cyclical growth. Every now and then commodity AND bond prices will trend higher in tandem and this tends to create a relentlessly strong equity market.

Bond prices bottomed in the autumn of 1981 while commodity prices continued to decline into the autumn of 1981. The equity market trend turned positive with bond prices even though prices were pulled lower for close to a year due to the weakness in cyclical growth. When the CRB Index finally reached bottom the SPX blasted upwards to return to the original rising trend line initiated back in 1981. Our point is that equity bull markets begin with rising bond prices even though the reason bond prices are rising- weakness in cyclical growth- is often so overwhelming that stock prices continue to decline until that pressure abates. Then, like a beach ball held under water, the equity market can literally explode upwards as it move back ‘on trend’.

The chart below right compares the U.S. 30-year T-Bond futures, Canada’s Bank of Nova Scotia (BNS), and telecom heavyweight Cisco (CSCO) from late 1999 through much of 2001.

The bond market turned upwards in early 2000 followed a few months later by the cycle peak for Cisco and the bottom for the Bank of Nova Scotia.

This is an interesting example because ‘tech and telecom’ provided the cyclical weakness that helped propel the bond market higher Even as the major equity indices declined entire sectors ranging from the home builders to the banks and even the pipelines advanced. Underneath the obvious ‘bear’ a new ‘bull’ was forming.

The page 1 point was that a positive equity market begins with falling interest rates even though the reason interest rates are falling- cyclical weakness- creates the impression of a negative trend. Perhaps the most dramatic example of a market or sector that simply couldn’t find bottom would be Japan where, some 18 years later, one wonders whether the combination of lower interest rates and asset price rationalization will ever end.

In any event the chart at top right shows the TBond futures, the ratio between gold and copper futures prices, and the ratio between the share price of Merrill Lynch (MER) and the CRB Index.

Bond prices bottomed in mid-2006 and again in mid-2007. In most instances identifying cyclical weakness is relatively simple but in this case it is proving to be a considerable challenge. The gold/copper ratio rises and falls with bond prices so we can see that there have been TWO rounds of lower interest rates since last year. The first went with commodity price weakness as the financials moved higher (i.e. the MER/CRB Index rose) while the second went with rising commodity prices and pressure on the financials
(the sub-prime debacle).

The MER/CRB Index ratio pivoted upwards yesterday as commodity prices declined and the financials rallied. If history is going to repeat we could potentially see the TBonds and the gold/copper ratio return to the previous lows as commodity prices move lower.

The chart below shows the U.S. Dollar Index (DXY) and the ratio of the rest of the world’s stock prices compared to the Dow Jones Industrial Index. The weaker dollar has gone with strength outside of the U.S. since the end of 2001.

One of the features of declining interest rates tends to be a rise in the value of equities relative to commodities. We have been following this trend using either the stock price of Schering Plough (SGP) or the broader pharma etf (PPH). When the MER/CRB Index ratio turned higher in the summer of 2006 the equity/commodity ratio rose which, in turn, went with a positive trend for the PPH. Ideally the equity/commodity ratio should go on to make new highs during 2008 extending the rally in the consumer and pharma sectors.