by Kevin Klombies, Senior Analyst

Thursday, October 11, 2007

Chart Presentation: Crowds

For as much as it may seem that the markets are in uncharted waters following new and often inexplicable trends… at times the similarities to all too recent events are almost overwhelming. For example on August 7th of 2006 BP stopped shipments of oil from Alaska’s Prudhoe Bay field due to a severely corroded pipeline and on August 10th- three days later- oil prices broke lower from the mid-70’s on the way eventually to 50.

Yesterday BP announced a 30,000 barrel per day production cut from Prudhoe Bay following a fire and oil prices gained just over 1 dollar to close above 81.

The upper chart below shows the rather peculiar combination of Japanese bonds and the Canadian dollar. The chart makes the case that since 2002 there have been three powerful rallies in this combination with the first beginning in the autumn of 2002, the second in mid-2004, and the third at the start of 2007.

Notice that the overall trend has not changed with each peak and trough higher than the ones before. If the overall trend includes both a stronger Canadian dollar and periodic flurries of strength in the long end of the Japanese bond market then we should not argue with it. On the other hand… given that it is our nature to argue with the markets as often as possible… we wanted to point out what has happened AFTER the combination of Japanese 10-year (JGB) bond futures and the Canadian dollar (CAD) futures reaches a peak (which, we are quite sure, it will once again some day).

Below right we have stacked charts of Japan’s Mitsubishi UFJ (MTU) and biotech Genentech (DNA) over top of the JGB times CAD combination. We could have used AMR, Alaska Airlines, or even something like Matsushita but this should suffice.

On the two previous occasions when the JGB times CAD combination was rockin’ and a rollin’ to the upside the trends for MTU and DNA were neutral to down right negative. When the combination finally reached a peak, however, the markets rotated back to these stocks taking them eventually to new highs. From our perspective one can either join the crowd chasing the current Asian/commodities theme or sit patiently until the next trend begins. Given our antipathy for crowds we prefer the latter option.



Equity/Bond Markets

At bottom are two chart comparisons that we have been following for quite some time. The charts consist of crude oil futures, the ratio between the stock prices of Caterpillar and Pepsi (CAT/PEP) and the stock price of Caterpillar (CAT). The top chart covers the time frame from March of 2006 into January or 2007 while the lower chart begins in May of this year.

The argument is that a peak for the stock price of CAT marks the start of a down trend for oil prices that will run until CAT finally makes a bottom. Obviously if CAT pushes up through this year’s July highs we will have to start the process all over again.

In 2006 CAT and the CAT/PEP ratio peaked in April and May and after the CAT/PEP ratio moved down below the 200-day e.m.a. line it found support around 1.10:1. In other words as long as CAT’s share price was more than 10% higher than PEP the trend was able to push oil prices upwards.

In early August just after BP’s announced shut down of oil supplies from Alaska the CAT/PEP broke below the 1.10:1 level and crude oil prices began the decline that would eventually end in January.

This time around the peak for CAT and the CAT/PEP ratio occurred in July with the ratio moving below the 200-day e.m.a. line before finding support at 1.05:1. The situation is very similar to last August but, as mentioned, for this to have any chance of working CAT has to already be in a declining trend. However our conviction that crude oil prices are headed back towards mid-2004 levels (40- 50) will increase substantially if the ratio between CAT and Pepsi breaks to new lows this month.

The basic argument has been that on the first decline from the peak for CAT the equity markets tumble only to lift upwards on a general rebound in equities followed by a new push from falling instead of rising energy prices. The trend at present continues to be dominated by the commodity stories with the ratio of the Amex Oil Index to the SPX grinding to the upside. We show this chart below. A very tedious upward trend that goes with strength in crude oil prices.