by Kevin Klombies, Senior Analyst

Tuesday, September 23, 2008

Chart Presentation: Bullville

The chart below compares the stock priceof Citigroup (C) with the yield spread or difference between 10-year and 3-month U.S. Treasuries.

The 10-year minus 3-month yield spread represents, to a large extent, the future. When the spread moves below the ‘0’ line it means that 3-month interest rates are higher than 10-year rates and when it rises to, say, ‘35’ it means that 10-year yields are 3.5% higher than 90-day TBills.

Over the past few decades each and every economic recession has been preceded by an inverted yield curve although each instance of the yield spread moving below ‘0’ has not led to a recession. The point is that an inverted yield curve is a serious negative for economic growth while a sharply widening curve serves as an economic accelerator.

In 2000 the spread moved below the ‘0’ line and this marked the start of serious downward pressure on the share price of Citigroup. The S&P 500 Index turned lower only to bottom out in the autumn of 2002.

Based on the observation that the yield spread moved negative back in 2006 marking a return to negative pressure on C as well as the U.S. economy the question today might be… how far along in the process are we at present? After all the yield spread turned positive in 2007 and is now approaching the highest levels set between 2002 and 2004.

Our view is that the process of creating the next bull market is well underway. The key, however, is that the stock prices of the major financialshave to stop making new lows.

Below we have included two charts of Citigroup. The top chart is from 2002 while the lower chart is from 2008.

In 2002 the share price of C made a bottom in July, a second bottom in September, and a third bottom into October. After testing the 25 level on three separate occasions the trend finally turned positive near the start of the fourth quarter.

In 2008 we can see that C made a bottom below 15 in July before testing the lows last week. The argument would be that this could drag on for days, weeks, or even months but if C snaps up through its 200-day e.m.a. line around 24 then the train to Bullville has left the station.



Equity/Bond Markets

In yesterday’s issue we mentioned that we would now be focusing on the dollar and the bond market. We showed, for example, that coming out of 1998’s Asian/LTCM crisis the financials hit bottom and began to rally followed by a strong dollar and weaker bond market. The ‘strong dollar/weaker TBonds’ combination tends to go with strength in the non-commodity cyclicals.

Today we will show the three remaining dollar and TBonds combinations.

Below we compare gold futures with the spread between the U.S. 30-year T-Bond futures and the U.S. Dollar Index (DXY). The trend for gold is similar to the trend for bonds minus the dollar so a stronger bond market and falling dollar tends to be a positive for gold prices. We should note that if the TBond minus DXY spread were to widen to more than ‘50’ (i.e. something like 122 for the TBonds and sub-72 for the DXY) then gold prices should hit new highs.

Below is a comparison between Coca Cola (KO), Merck (MRK), and the sum of the TBonds and DXY from 1994 into 1998.

When the dollar AND the bond market is stronger then the trend favors the large cap consumer growth, pharma, and financials.

Below we feature a comparison between the sum of copper and crude oil and the sum of the TBond and DXY from 2001 into 2008. The trend from post-9/11 in 2001 into 2008 featured weakness in both the dollar and the bond market. In other words the trend was virtually the mirror image of the trend that dominated from 1995 into 1998. When the dollar and bond market are weaker we tend to get an upward push for energy and base metals prices. A stronger bond market favors gold prices while a weaker bond market tends to favor the base metals.

Right or wrong we still favor the dollar and tend towards a positive view on bond prices. In terms of the equity markets this keeps us leaning away from the commodity sector and towards large-cap U.S. growth.