by Kevin Klombies, Senior Analyst

Wednesday, March 19, 2008

Chart Presentation: Crude Comments

Well at least the markets aren’t boring these days.

The Fed continues to reduce interest rates to stimulate growth while the People’s Bank of China aggressively tightens monetary conditions to control inflation. Goldman Sachs commented yesterday that it expects a 1/4% rate cut by the Bank of Japan over the next few months while the ECB takes a page out of the Volcker Fed’s book back in 1981 and remains ever so vigilant with respect to inflation. Something for everyone, we suppose.

We are going to return to one of the arguments that we made on occasion last year. The chart at right compares the stock price of AMR and crude oil futures from early 2006 into early 2007.

The last peak for oil prices occurred in August of 2006 and this went with the lows for the share price of AMR. Fair enough. Our point, however, is that while the airlines largely stopped going lower once oil prices finally reached a top the start of a rising trend had to wait until early September after crude oil futures prices had broken below the 200-day e.m.a. line.

Through 2007 and into 2008 our general view has been that we are completely ready to like the airlines but only once crude oil futures break the moving average line and to date that has not happened. Meanwhile AMR has managed to decline from over 40 to under 10.

The chart below right compares the U.S. Dollar Index (DXY) with crude oil futures.

The point, of course, is that crude oil futures prices are unlikely to decline much less break an important support level while the dollar is making new daily lows. Last August the DXY was 12 points higher than oil prices (82 vs. 70) while into mid-March the spread had widened to the point where crude oil was close to 40 points higher than the dollar.

In order to get back to the point in the cycle where the airlines start to fly we need to see lower energy prices and for that to happen the dollar has to firm up. More than ‘firm up’, actually. The DXY has to be ready to at least take a run at its 200-day e.m.a. line because if it simply goes flat as it did between November and February then crude oil prices are going to range trade back and forth through the 50-day e.m.a. (i.e. between 95 and 115).



Equity/Bond Markets

With commodity prices rising and equity prices declining it has been obvious that the hot or momentum-based trade that has been working of late is to be long crude oil or gold while being short the equity markets. The problem is that, by and large, this trade is predicated upon some combination of financials markets chaos and impending doom so if it works ‘too well’ there won’t be any banks left to deposit the profits from the trade.

The chart below compares the stock price of Fannie Mae (FNM) with the ratio between the Dow Jones Industrial Index (DJII) and gold futures. In essence being short the Dow and long gold was and is very similar to being short Fannie Mae. Given that FNM rose more than 25% yesterday it wasn’t too surprising that the equity markets were higher while gold was lower.

When crude oil prices are strong and rising the oils tend to outperform the broad U.S. stock market. In other words the ratio of the Amex Oil Index (XOI) to the S&P 500 Index (SPX) will go UP.

On page 1 we commented that the start of a rising trend for the airlines tends to go with crude oil prices moving back below the 200-day e.m.a. line. In the past we have argued that this should also go with a similar break down by the XOI/SPX ratio.

At right we show the XOI/SPX ratio and crude oil futures from 1986 through 1987 and from late 2006 to the present day.

The idea is that several months before crude oil prices finally reached a peak in July of 1987 the XOI/SPX made a ‘double top’ and then turned lower. In other words the oil stocks began to weaken relative to the broad market ahead of the top for crude oil prices. Something reasonably similar has been happening this year as the XOI/SPX ratio has so far failed to make new highs even after crude oil futures extended the rally up from 100 to 111. The bad news, we suppose, is that it is difficult to put a bullish spin on the equity markets when using a comparison to the third quarter of 1987 just ahead of the October stock market ‘crash’.