by Kevin Klombies, Senior Analyst

Wednesday, May 21, 2008

Chart Presentation: Challenges

Crude oil futures prices continued to push higher yesterday while various equity indices in Hong Kong and China declined by anywhere from 2% to 5%. The financials were weaker as long-term Treasury yields moved somewhat lower and in response to the weaker dollar and lower interest rates gold prices rose rather sharply. In other words… more of the same.

It is our view that one of two things will likely happen. Either crude oil prices will continue to rise forever or they will eventually peak. Given our bias towards viewing the markets in terms of alternating cycles we tend to favor the latter outcome and it is our conviction that when oil prices do reach a top that price will stand for years to come.

It is not much of a challenge to pick sectors which will do well once energy prices peak because, in general, they are exactly the names that have performed the worst over the past couple of years. Consider that the broad commodity trend runs with Asian growth and then recall that the last bottom for non-Japanese Asian growth was made in the autumn of 1998. From 1998 into 2008 the Airline Index has fallen from around 210 to 21 which, we tend to believe, argues in favor of owning the autos and airlines once we find the ‘other side’. That is the easy part; the more difficult task is trying to figure out whether crude oil at 130 is high enough or whether the ultimate peak will be at 150, 200, or perhaps even 400.

We have included at right the chart comparison between the share prices of Wells Fargo (WFC) and Carnival Cruise Lines (CCL) along with the ratio between the Amex Oil Index (XOI) and the S&P 500 Index (SPX).

The idea is that similar to 1990 the peak for crude oil futures will go with the bottoms for WFC and CCL. When these stocks are set to push back up through their 200-day e.m.a. lines then the ratio of the oils (XOI) to the broad market (SPX) will be set to break below its moving average line.

The problem has been that WFC has made three forays above its moving average line since January with CCL rising to within a fraction of a point of its potential break out/trend change line. On all three occasions the markets have swung- hard- back to the energy theme leading to an escalation not only of oil prices but also of the relative value of the oils compared to the broad market. This will go on until it ends, of course, but it would be nice to have something else to write about for a change.


Equity/Bond Markets

One of our views- mentioned on page 1- is that commodity prices trend with Asian growth. Given that Asian growth bottomed in 1998 with the Asian crisis the current commodity trend is now close to 10 years old.

We mention this because another of our views is that the markets rotate from bubble to bubble. It is our conviction that oil prices have or will reach levels that are as over done to the upside as the share prices of the large cap consumer and pharma stocks into the late 1990’s or even the Nasdaq into 2000. Eight to ten years later stocks such as Coke, Merck, and even Wal Mart remain below their record highs even as earnings and dividend payouts have grown while the Nasdaq’s close just below 2500 puts it at only 50% of its cycle peak.

In any event at right we have included two charts of 10-year Treasury yields (TNX). The top chart of from early 1999 into 2000 while the lower chart is from early 2007 to the present day.

The rather obvious point is that the two charts are virtual mirror images of each other with the peak for yields in January of 2000 lined up with the bottom for yields set in March of 2007.

The argument has been that interesting rates were ‘trending’ higher along with the capital spending theme into 2000 and as they pivoted back to the down side it marked an early warning indicator of an impending trend change for the equity markets. The Nasdaq topped out a couple of months later as capital spending and interest rates collapsed through into 2003.

The recent trend is almost the exact opposite of 1999- 2000 as Treasury yields trended lower along with the consumer spending- driven theme that has gone with rising commodity prices. The charts suggest that if yields truly bottomed in March then another major trend change for the equity markets is due.

Below we show that the final peak for the Nasdaq in 2000 was made just as 10-year yields bounced up off of the 200-day e.m.a. line. The chart for crude oil shows that the last bit of oil price strength has gone with 10-year yields failing lower after reaching the moving average line last week.