by Kevin Klombies, Senior Analyst

Thursday, June 7, 2007

Chart Presentation: CAT/Coke

Equity prices were sharply lower yesterday following a higher than expected U.S. employment cost report and an increase in interest rates by the European Central Bank to 4%.

We have argued on many occasions that U.S. short-term interest rates are trending with energy and metals prices so as long as copper and crude oil futures prices remain below last year’s highs we would not expect the Fed to raise the funds rate. On the other hand… it would also be true that the Fed will not reduce the funds rate as long as energy and metals prices are showing strength.

We show two comparative charts of the U.S. 30-year T-Bond futures and the ratio between Caterpillar (CAT) and Coca Cola (KO). The top chart covers the time frame from early 1986 through 1987 while the lower chart starts in early 2006.

It has been our view that energy and metals prices peaked in 2006 which led to the top for short-term U.S. interest rates and the start of a significant equity markets rally that would last (at least) into this summer.

It has also been our view that in a flat to declining commodity price trend consumer stocks like Coke should do better than cyclical stocks like CAT and that this would broadly go with declining interest rates.

The problem is that we might be absolutely correct or potentially dead wrong. One might think that we should know the answer to this but our explanation would be that the CRB Index is still sitting right on its moving average lines which means that the recent rally has taken it from negative back to neutral. If we are right it resolves lower and if we are wrong then it break upwards. Fair enough.

In the spring of 1986 the CAT/KO ratio pivoted higher as the commodity cyclical trend turned positive. In response bond prices began to decline based on concerns about inflationary pressure. The bottom line is that bond prices fell as the CAT/KO ratio moved upwards and this continued right into the autumn stock market ‘crash’.

The point is that in a manner quite reminiscent of 1987 the CAT/KO ratio turned higher earlier this year concurrent with a turn lower in long-term Treasury prices. If the cyclicals continue to dominate through the summer in the face of rising interest rates then the 1987 outcome- a stock market collapse- becomes a very real possibility.



Equity/Bond Markets

In October of last year the stock price of Wal Mart gapped upwards only to trade below the highs for four trading sessions and then gap right back to the original trading level. In February of this year WMT gapped upwards, traded near the highs for four trading sessions, and then broke lower. We mention this because WMT’s sharp price increase may or may not mark the start of a trend change but it would be encouraging if it pushed to new highs over the next few days.

The upside surge in WMT occurred at the same time that the Chinese equity markets were starting to weaken. The Chinese equity markets have been trending higher with base metals prices so the argument would then be that if WMT’s rally is ‘real’ then it marks the start of weakness in metals prices and the Chinese equity market.

Another view of this argument is shown below using copper futures and the ratio between the Morgan Stanley Consumer Index and the Morgan Stanley Cyclical Index.

The equity markets favor the cyclicals when copper prices are rising and turn back to the consumers when metals prices weaken. The consumer/cyclical ratio is back to a level roughly equivalent to that of May 2006 as copper prices reached a top. The point is that this could be a top for copper and this could be the start of a sustained rally in WMT but… if it isn’t… then this is going to feel more and more like 1987 as the months pass.

The chart below compares 10-year Treasury yields with the product of the Australian dollar times copper prices.

The argument is that once the AUD times copper peaks so too do long-term Treasury yields. The recent recovery in copper and the AUD has pushed yields back towards last year’s levels.