by Kevin Klombies, Senior Analyst

Wednesday, July 25, 2007

Chart Presentation: Cyclical Trend

While there may be any number of potential outcomes for the markets three in particular come to mind. From the equity market’s bottom in 2002 through to the present day the trend has been positive based on expanding economic growth and rising earnings. We tend to view this as a positive cyclical trend.

The first potential outcome would simply be more of the same with the positive cyclical trend dominated by rising commodity prices. A second outcome would be a shift within the trend so that the non-commodity sectors could take a turn. The third outcome would be the end of the positive cyclical trend on the way potentially into recession.

The chart shows the stock price of Boeing (BA) and the Baltic Freight Index. The BFI is an index of dry cargo ocean freight rates and unlike markets like crude oil, nickel, and copper it represents real money doing real things. When the BFI is strong and rising it means that the cyclical trend is positive.

We rather like Boeing because it has such a well defined and rising channel. Unlike many of the more cyclical sectors it simply plows onward and upward. We are using the BFI to represent the health of the cyclical trend and the stock price of BA to represent the overall trend for the U.S. equity markets. Obviously both continue to rise.

Within the cyclical trend there are sectors that are likely ‘too high’ and other sectors that are ‘too low’. When the cyclical trend focuses on the commodity sectors it has a negative impact on sectors like airlines. Today however we are going to compare a mining stock (Freeport McMoRan- FCX) with a biotech (Genetech- DNA).

The charts suggest that DNA has reacted negatively to two trends since the end of 2005. The first was a recovery in shipping rates that more than tripled the BFI between the start of 2006 and the summer of 2007. The second was the major recovery rally in the oils and mines that began at the start of 2007. The rise in FCX this year has gone almost tick for tick with the decline in DNA.

Our view is that FCX is ‘high’ relative to its base trend while DNA appears to be closer to its channel bottom. If the positive cyclical trend remains intact then the charts make the case that the biotechs should swing higher while money moves away from the metals and miners.



Equity/Bond Markets

We still favor the second of the three potential outcomes- a positive cyclical trend that rotates away from the commodity sector. We assure one and all that in an equity bear market the biotechs are not the best place to be.

The chart compares DNA, crude oil futures, oil refiner Valero (VLO), and the ratio between the oils (XOI) and the airlines (XAL).

The XOI/XAL ratio finally broke the rising trend yesterday as crude oil prices declined and VLO continued to decline. Of the few stocks to rise in price yesterday we noted that Genentech ended the session a bit better.

The XOI/XAL ratio has bottomed out between 16:1 and 18:1 at the lows for crude oil so we have argued in the past that this should help us find the next bottom for crude. All things considered and keeping in mind that it was a ‘Tuesday’- the day in front of the weekly energy inventory report- it did appear that yesterday was the first day of the correction for energy and metals prices.

Below we show two charts of Wal Mart (WMT) and gasoline futures. We worked these up during trading yesterday as WMT was higher in the face of lower gasoline prices. By the end of the day the pressure from falling equity index futures pulled most stocks into the red.

The idea was that when WMT bottomed at the peak for gasoline futures in July of 2006 it led to a rally that pulled WMT up to around 52 in late October. If WMT’s bottom this year was made in May at the peak for gasoline futures then it should have started to climb in price in July on the way to something between 55 and 56 toward the end of August as gasoline futures prices correct back to 1.50.