by Kevin Klombies, Senior Analyst

Monday, March 3, 2008

Chart Presentation: CAT and VLO

For good or for bad we approach the markets with a bias of sorts. Our macro view is that the markets swing between the commodity theme and the non-commodity theme roughly every six or so years creating peaks in the relative strength of the share prices of the major mining companies in 1981, 1994, and 2007. As we begin the third month of 2008 we still are not sure whether our view- or bias- that the equity markets’ commodity theme reached a peak during the fourth quarter of 2007 will turn out to be accurate but we do know that crude oil prices over 100 combined with copper prices pushing back towards the 2006 highs do little to support our thesis.

We start off today with a comparative view between the S&P 500 Index (SPX) and the sum of the share prices of Caterpillar (CAT) and Valero (VLO).

We tend to use CAT and VLO to represent the commodity theme so from this perspective our conclusion that the commodity theme made some sort of top last year may not be so far fetched. The problem is that the equity markets have been trending with the commodity theme so each time CAT and VLO decline in price the SPX goes along for the ride.

Over the past few days our page 5 argument has been that CAT and VLO have been leading crude oil prices which in turn have been leading the euro upwards against the dollar. We then observed that if CAT and VLO turn lower to lead energy prices back to the down side the only way the equity markets will hold or rise is if the equity markets bid the share prices of the large cap consumer and pharma names higher in response to weakness in commodity prices.

The chart below rather clearly shows that the trend for CAT and VLO has been almost identical to that of the SPX which explains- at least in part- why the equity markets were so weak last Friday.

On the other hand if we view the same comparison through 2006 we get a much different picture. The peak for CAT and VLO between April and August of that year went with the lows for the SPX and as these two stock weakened the SPX lifted higher.

The different reactions by the S&P 500 Index in 2006 and 2007- 2008 to weakness in CAT and VLO are, in our view, related to the trend in crude oil prices. In August of 2006 oil prices broke lower and the equity markets pushed upwards. To date oil prices have remained strong and, as we know, the equity markets have declined.



Equity/Bond Markets

Below we show Valero (VLO) and the ratio between crude oil futures prices and gasoline futures.

At present the ratio of crude oil to gasoline is at the top edge of the long-term trading range. In other words- all things being equal- either oil prices have to decline or gasoline prices have to rise so that the ratio can hold within the .27 to .41 trading range.

Downward pressure on VLO reflects the position of this ratio because it shows that refinery profits are being squeezed. In a perfect world with gasoline inventories already well above the 5-year average this would lead to a reduction in demand for crude oil for refining purposes and ultimately lower prices. At roughly 2.51 for gasoline futures as of the end of last week a ratio of .41 would go with crude oil prices just under 103 while a ratio of .27 would go with crude oil prices closer to 67.

Below we show two charts of the share price of Schering Plough (SGP) and crude oil futures. The chart below runs from June of 2006 through August of 2007 while the chart below right begins in June of 2007 and runs to the end of last week.

In both 2006 and 2007 the markets made a significant change in trend during July and August. In 2006 crude oil prices turned lower and in response the stock price of SGP began to rise higher from the 20 level. A year later in 2007 the trend for crude oil prices began to rise which went with a declining trend for SGP all the way back to the 20 level.

We have set up the charts so that crude oil is on the bottom between 2006 and 2007 while SGP is on the bottom from 2007 into 2008. The argument is that oil prices pivoted higher in January of 2007 and then returned to the 2006 highs by the summer of 2007. If SGP were to follow a similar path then the lows set in January of this year would hold with prices rising back towards 33 some time this summer.