One of our basic views is that the problem isn’t that the cyclical sectors are weak but rather that the consumer sectors aren’t strong. Now we have to try to find a way to explain what we mean by this.

The S&P 500 Index is divided into two groups represented by the Morgan Stanley Consumer Index and Morgan Stanley Cyclical Index. The former consists of names like Coca Cola, Pepsi, Merck, Pfizer, Johnson and Johnson, Wal Mart, Gillette, etc. while the latter includes Dow Chemical, Alcoa, Deere, Caterpillar, Citigroup, etc.

The equity markets have been falling since mid-2007 on both absolute and relative weakness in the cyclicals. In other words the ratio between the consumer and cyclical indices has risen even as the S&P 500 Index has declined. On any given day if the energy and basic materials sectors are negative the stock market is lower and if these two sectors are stronger then the stock market has tended to be higher.

The reality is that the stock market has been trending with the cyclical sectors for years but it is also true that this has not always been the case. Between early 1994 and 2000 the S&P 500 Index more than tripled as the consumer/cyclical ratio pushed upwards.

We have argued (rather relentlessly) that the consumer and health care sectors would outperform the commodity cyclicals.. and they have by a wide margin. We have argued that the S&P 500 Index would outperform most if not all of the major global equity markets and it has and we were right on the mark that large cap was due to outperform small cap.

The problem is and has been that robust relative performance is nice to write about but the idea is to have robust actual performance. The Morgan Stanley Consumer Index has doubled relative to the Cyclical Index since mid-2007 but only because it has fallen at a slower pace and THAT is our problem.

Much of this is preamble to the point that we wish to make on the following page but the basic ideas represented by the chart below are as follows: the S&P 500 Index has been range bound between roughly 775 and 1550 for close to 12 years, the S&P 500 Index can and has risen when consumer themes are stronger than cyclical themes, and the ratio between the consumer and cyclical indices has risen very close to the levels that were associated with the stock market’s peak in 2000 and the bottom made during the 4th quarter of last year.

In a sense this is actually a bullish argument in that from here the consumer/cyclical ratio only has two ways that it can resolve- higher or lower. If it declines then we will argue that the stock market will get a lift as cyclical strength builds but if it rises… then it will break to new highs which is, of course, the argument that we wish to show on the next page.


Equity/Bond Markets

Belowwe show the Japanese yen futures from 1977 through 1988 and the stock price of Abbott Labs (ABT) from 2000 to the present day. ABT falls very clearly into the ‘consumer’ category.

We argued recently that yen strength may end up being a positive for the Japanese stock market because… when the yen finally broke to new highs in 1986 after holding for close to 7 years below the end of 1978 peak… the Nikkei began to seriously outperform most global equity markets.

Our thought is that cyclical weakness will always lead to falling stock markets until such time as the major consumer stocks start to show actual price strength. Abbott is one of the key representatives of the ‘consumer’ theme so it would have to break up through 60. In other words… new highs for the consumer/cyclical ratio shown on page 1 could, in fact, be a positive but only if this goes with or leads to actual price break outs for stocks like Abbott Labs.

New topic. Below we show crude oil futures and the spread between the S&P 500 Index (SPX) and the Amex Oil Index (XOI). The SPX minus XOI spread falls when the oils are stronger than the broad market and rises when the broad market is stronger than the oils.

The first point is that oil prices collapses in both late 1985 and 1990 went with a sharply rising SPX minus XOI spread. In other words… as one might expect… falling oil prices have generally been viewed as a negative for the share prices of the major oil producers. The problem (read: ongoing frustration) this year has been that no matter badly oil prices decline the oil stocks simply refuse to weaken relative to the broad market. Our view is that the trend dominated by rising energy prices began back in 1999 and has been driven by a weak yen versus the euro. Our view is that the stronger the yen against the euro the greater the likelihood that the XOI will actually decline relative to the SPX.