by Kevin Klombies, Senior Analyst

Thursday, June 28, 2007

Chart Presentation: Cycles

Over the last few weeks there has been civil unrest in both Nigeria and Iran over the cost or availability of gasoline. Perhaps the mysterious series of refinery shutdowns for unplanned maintenance in the U.S. was part of a broad political destabilization plan. Strange days indeed.

Yesterday was, of course, not a Tuesday so energy prices rallied. Within the equity markets, however, there was a bit too much strength in energy sensitive names like GM and a bit too much weakness in stocks like Valero to make us believe that the trend is still wholly intact.

We thought we would show something a bit different today. On many occasions we have shown that the stock price of Boston Scientific (BSX) trends higher and lower with short-term U.S. debt prices. In other words when short-term interest rates are falling the stock price of BSX tends to rise and vice versa.

Let’s start with a premise. When the Fed attempts to slow the economy it succeeds and when it attempts to stimulate the economy it also succeeds but in both cases there is a lag between the change in policy and its ultimate impact.

We have set up charts with each lagging the next by one year. We show, for instance, the peak in BSX in 2004 over top of the peak in the home builders (DR Horton plus Hovnanian) in 2005, the highs for commodity prices in 2006, and now the cycle top for Nucor in 2007.

The basic idea is that BSX represents the leading edge of the Fed’s intent to slow economic growth. Since it trends very closely with short-term yields it turned lower in 2004 while the home builders managed to party on for another year before succumbing to the pressures created by rising interest rates.

One year later the CRB Index turned lower as the slow down in the U.S. housing market began to impact the demand for raw materials. Typically once commodity prices stop rising the equity markets lift as interest rates pressures abate and this goes with a period of intense takeover activity which helps keep the metals and miners trading higher.

Our thought is that by late this year we might have some interest in going positive on the home builders on weakness but it is going to be at least a year before we are ready to turn back to positive on the commodity sector. As for the mines, oils, steels, etc… we can’t imagine going positive on them any time soon unless the correction process is accelerated through a ‘crash’ later this year.





Equity/Bond Markets

The argument that cyclical sectors are swinging off of 2004 prices appears to have at least some merit when we view the comparison below of U.S. home builder Beazer Homes (BZR) and Anheuser Busch (BUD). An excess in one market can create a paucity in another.

We show a comparison between Coca Cola (KO) and Oracle (ORCL).

Oracle reached roughly 15 in 2004 before correcting back to 10. When the stock finally broke up through 15 it continued to push upwards until it reached 20. In other words its initial target above 15 was equivalent to the distance that it corrected down from 15.

If we use this template on KO we see that the 2004 peak was roughly 54 followed by a correction back below 40. This sets up the potential for a 14- 16 point ‘swing’ north of 54 if this resistance line is ultimately broken.

We show a comparison between 3-month U.S. TBill yields, the stock price of Schering Plough (SGP), and the ratio between equities (S&P 500 Index) and commodities (DJ AIG Commodity Index).

We return to this chart on occasion just to prove to ourselves that the markets really aren’t doing anything overly new or unexpected. Our interpretation of the trend obviously needs work but the trend itself is actually quite normal.

The argument was that when TBill yields reach a peak- as they did at the end of 1994 and again in mid-2006- stocks like SGP should begin to lift and equities would start to outperform commodities. So far, so good.

The point that we obviously did not take into account is that in any trend where equities outperform commodities… the stock price of commodity producers will do very well during those period of time when commodity prices are rising. Like the first half of this year. The argument did not say that commodity stocks would turn negative but instead suggested that the broad trend for commodity prices would be negative.