by Kevin Klombies, Senior Analyst

Wednesday, April 30, 2008

Chart Presentation: Chaos

The Federal Reserve is widely expected to cut the funds rate by 1/4% today to 2.0% and, in general, the Fed follows the dictates of the markets. However, it isn’t what the Fed does or doesn’t do today that is important but rather what the markets do in response. From any number of angles and perspectives the markets appear to be on the verge of something approaching pure chaos so this should make for an interesting next few days.

When we use the word ‘chaos’ we aren’t referring to something necessarily negative- because there are no good or bad days in the markets, only days when one is right or wrong with the trend- but instead are pointing towards the potential for jaw-dropping volatility.

Moving on- for the moment- we show at top right a chart comparison between the CRB Index (commodity prices) and the ratio between the Canadian and U.S. equity markets.

The simple point here is that a rising commodity trend is a positive for the Canadian equity market and leads to a rising Cdn/U.S. ratio. On the other hand weakness in commodity prices swings the pendulum back in the other direction which explains why the S&P/TSX Composite Index (Canada) was down 260 points yesterday compared to a mere 40 point decline for the Dow Jones Industrial Index.

Below right we show the CRB Index once again along with the ratio between the pharma etf (PPH) and the share price of Caterpillar (CAT).

The argument here is that peaks for commodity prices go with bottoms for the pharma/CAT ratio so in theory once commodity prices start to weaken the pharma sector should outperform.

The problem with the major pharmaceuticals is that there seems to be an almost unending stream of bad news. Merck’s stock price declined roughly 10% yesterday after the FDA denied approval of a new cholesterol drug which makes this an odd point in time for this group to start outperforming the broad market. In other words when money finds no reason to push back towards pharma it tends- time and time again- to move into those sectors that have been showing positive momentum. Our point is that while we are looking for a trend change that would favor pharma yesterday’s action in Merck as well as Genentech was somewhat less than encouraging.



Equity/Bond Markets

Below we show the U.S. Dollar Index (DXY) futures and the yield index for 3-month U.S. TBills.

The low for TBill yields was reached in mid-March concurrent with the lows for the dollar. Over the past few weeks the dollar has held below the 73’ish level while TBill yields have made numerous attempts to cross up through 1.50%.

The key today is how the markets respond to the Fed’s decision. If short-term yields continue to climb and the dollar moves on towards 74 then we will take that as a positive.

Below right we show Japan’s Mizuho Financial (MFG) and the gold etf (GLD). We typically use Mitsubishi UFJ (MTU) when viewing the Japanese banks but today we have chosen to include MFG- for no particular reason.

In mid-March as TBill yields and the dollar bottomed the stock prices of Japan’s banks began to rise. At the same time gold prices peaked and turned lower so we will argue that the positive outcome mentioned above could easily be intensely negative for metals prices.

Below we show Rio Tinto (RTP) and a chart of the S&P 500 Index from 1989.

If there is one thing that can create ‘chaos’ it is a failed break out. In October of 1989 the SPX broke to new highs but after a few days it circled back to the break out point and then promptly collapsed. RTP’s decline yesterday on lower metals prices brought it back to support which is why we used the term ‘chaos’ for our headline today.