by Kevin Klombies, Senior Analyst

Monday, October 22, 2007

Chart Presentation: CAT

Equity markets ended last week on the defensive (i.e. lower) as the U.S. dollar sank to new lows whilecrude oil futuresprices stalled on the drive towards triple digits. As early as last Tuesday the markets suggested that there was just less than a 40% chance of a 25 basis cut in the funds rate at the end of this month but by end oftrading on Friday this had increased to more than 90%. In other words in just over a week there is a very strong chance that the equity markets will be responding to a second reduction in U.S. interest rates.

We return once again to our comparison between thestock priceof Caterpillar, the ratio between CAT and Pepsi, and crude oil futures. Below we show the relationship from 2006 while below right we show it for the current time period.


The premise is that CAT’s stock price represents the trend for thecommodity cyclical sector so when it peaks and turns lower it suggests that the underlying trend forcommodity pricesis weakening. As long as CAT is pushing to new highs the trend for energy prices is stronger but once CAT turns lower the trend foroil pricesswings from positive to negative.

The twist is that last year oil prices apparently found any number of reasons to continue to rise after CAT and the CAT/PEP ratio turned lower in 2006 and that on the first decline for CAT the S&P 500 Index suffered a fairly significant correction. Three months later the story was much different because the decline in CAT went with the start of oil price weakness which, in turn, helped to lift many of the non-commodity sectors that had been under pressure. In any event CAT returned to itsmoving averageline on Friday, the CAT/PEP ratio moved back to support, and all things being equal we thought the week ended on a somewhat encouraging note.


Equity/Bond Markets

At right are two charts of the pharma etf (PPH). The chart at top right is from 2006 while the chart below it is from 2007.

We are trying to show the path that the PPH followed in 2006 as the commodity markets worked through the double-top that began with the peak in copper prices in May and the subsequent peak forcrude oil pricesthree months later in August.

The PPH declined with the broad equity market from May through June and then turned higher at the end of the quarter as thebond marketsbegan to lift in price. To show this we have included a chart of the U.S. 5-year Treasury futures at bottom right.

The PPH flagged lower through early August as oil prices pushed to the peak and then resolved higher. This shows how and why the S&P 500 Index was able to rise in the face of lower oil prices.

The set up this year is quite similar as the PPH slumped into August following the July peak in copper prices andstock such as CAT and then turned higher in September following the bond market’s upside break out. Through last week the PPH was correcting lower in a manner quite reminiscent of August of last year.

We show another view of this relationship below using the PPH and the ratio between the SPX and the DJ AIG Commodity Index (equities/commodities). The ratio made a bottom between May and August as commodity prices peaked and then pushed higher on rising bond pricesand strength in the consumer and pharma sectors. This year the ratio has held between roughly 8.4:1 and 9:1 as commodity prices have worked through the top so the bullish equity markets argument rests in large part on both lower oil prices and rising bond and consumer stock values.