March 4 (Bloomberg) – Stocks rose around the world, commodity prices rallied and Treasuries fell on speculation China will broaden efforts to boost growth…
Many years ago we wrote that this decade would be about all things China so perhaps it is fitting for us to blend this view in with our ‘decade trend’ theme today.
The ‘decade trend’ basically suggests that the cyclical trend has been following a similar pattern over the past few decades with peaks in the ‘0’ year, bottoms late in the ‘2’ year, crashes and collapses in the ‘7’ year, and renewed cyclical strength around the start of the ‘9’ year. In other words… even though we are well and truly mired in one of the worst economic slow downs in many years the idea is that a positive cyclical trend should have begun towards the end of 2008 and that as it pushes through into March (i.e. right about now) it will begin gathering positive momentum.
The problem is… in a world where global growth is not only weak but is apparently getting weaker by the day… is there a cyclical sector that is actually on the rise? The only answer that makes sense is China.
Belowwe show the Philadelphia Semiconductor Index (SOX) and the spread or difference between the Fed funds target rate and 3-month U.S. TBill yields from April of 1998 through September of 1999.
The Asian crisis occurred in the autumn of 1998 extending into 1999 as both Brazil and Russia collapsed. The tech sector (SOX) turned higher in October of 1998 with the bottom occurring at the peak for the spread between the funds rate and TBills. To explain quickly… no matter what the absolute level is of the Fed funds rate it is monetarily ‘tight’ if it is higher than TBill yields and ‘easy’ if it is lower than TBill yields.
The argument would then be that Chinese equities today are like the tech sector in March of 1999. The Shanghai Composite Index bottomed last autumn as the spread between the funds rate and TBill yields spiked upwards and as the yield spread has narrowed in Chinese stocks have pushed higher.
The most bullish argument that we can make at present is that there is a major cyclical sector already on the rise and from the recent strength in copper prices the most logical candidate would be China.
Today’s thesis is that while the markets fixate on U.S. car sales, home prices, and employment data the leading edge of the ‘cyclical train’ left the station four or five months ago. If so then when did it start to show up in the U.S. equity market? Perhaps yesterday.
The stock market is being driven by cyclical strength. The ratio between the Morgan Stanley Consumer and Cyclical indices reached a multi-year peak at the end of trading on Tuesday. If the stock market has bottomed then this ratio has to have peaked.
For months (and months) we have argued that a lasting stock market recovery will require relative weakness in the oil stocks (XOI). We are not suggesting that oil prices have to decline from current levels but rather that the oil stocks- which are trading like consumer defensives- have to fade from market leadership. To show what we mean we have included a comparison between the S&P 500 Index and the ratio between the Amex Oil Index (XOI) and Airline Index (XAL) from 2002 through most of 2003 below. The rather straightforward point is that the oils outperform the cyclical sectors (i.e. airlines) during bear markets. Regardless of what oil prices do the next stock market recovery should begin with relative strength in the airlines.
The argument that we are circling begins with the proposition that a broad cyclical recovery requires an ‘early leader’. The tech sector turned upwards in the autumn of 1998 even as copper and crude oil prices declined to new lows. The chart comparison at below shows that the sum of copper and crude oil did not bottom until late February in 1999.
Our thought is that if China today is similar to the Nasdaq in 1998 then the S&P 500 Index today could be similar to energy and base metals prices in 1999.
