by Kevin Klombies, Senior Analyst,

One can’t help but think after watching Citigroup and Wells Fargo go to the mats over the carcass of Wachovia that there are those out there who believe that current market prices for many of the financials represents rather compelling value. A view, of course, at odds with the panic-driven selling in the equity markets.

Below we show a chart of the CRB Index and the U.S. Dollar Index (DXY) futures.

We have recently made any number of arguments but we are going to circle back towards two of them. We are and have been dollar positive and have suggested that dollar strength will serve to pull commodity prices
lower. The first target for the DXY was the 81- 82 level which was reached yesterday. This was the level that was supposed to mark the bottom for the S&P 500 Index.

We have also argued that the final stages of the correction could well be focused on the commodity markets with the ratio of the CRB Index to the S&P 500 Index falling sharply. In terms of numbers our expectation was that the CRB Index would move down to around 286 which would serve to lift the SPX back towards 1300.

While we wouldn’t be at all surprised to see the dollar back down today the chart at top right suggests that it might have to rise as high as 85 before the CRB Index can be pulled down to 286. To get from here to there will take weakness in crude oil prices that, we suspect, could only come after some sort of surprise build in the weekly energy inventory report.

There may be any number of things ‘wrong’ with the equity markets but the one that continues to stand out to us is the way equities are falling at roughly the same pace as commodity prices. The CRB/SPX ratio, for example, has been stuck at the 200-day e.m.a. line since early August. If the SPX was stocked full of commodity
producing companies this might make sense but… it isn’t. Our expectation was that the CRB/SPX ratio would snap back down to levels associated with early 2007 and that in the process this would actually lift the U.S. equity markets higher.

When we ponder the potential for the CRB/SPX ratio to decline all the way down to .22:1 we only have to look at something like the Australian dollar futures to realize that this is imminently doable.



Equity/Bond Markets

Below we compare a chart of the U.S. 30-year T-Bond futures from May through December of 1987 with the S&P 500 Index from 2008.

Our point is and has been that while equity price weakness in 1987 caused the bond market to snap upwards the recovery did not begin until the equity markets had first hit bottom. In other words the rise in the bond market was caused by weak equity prices but did not begin until equity prices had found support.

Our view has been that the CRB/SPX ratio today is similar to the SPX/TBonds ratio in 1987. If so then the daily grind lower in the SPX is also similar to the relentless weakness in the TBond futures into mid-October. Our argument has been that the CRB/SPX ratio will decline to around .22:1 and originally we were using 310 for the CRB Index and 1400 for the SPX before shifting the numbers down to 286 and 1300.

The point? First, the CRB Index closed at 309.70 yesterday. Second, when it reaches bottom be prepared for a very sharp equity markets rally.

Below is a comparison between Coca Cola (KO) and the ratio between oil service giant Schlumberger (SLB ) and crude oil futures.

The charts are virtually identical. The trend for KO will be positive if SLB is rising faster than crude oil or, conversely, falling at a slower pace. The best way for KO to move upwards is for crude oil prices to move lower.

Below we show 10-year Treasury yields (TNX) and the ratio between Johnson and Johnson (JNJ) and the S&P 500 Index (SPX).

This is a very simple point. JNJ outperforms the broad U.S stock market
when the trend for long-term yields is lower. The weaker the economy the lower yields will go and the better JNJ will do on a relative basis. Of course rising on a relative basis when the broad market is falling at a pace of 5% per day isn’t particularly profitable but this does at least show why JNJ tends to do quite nicely when the rest of the market is coming apart at the seams.