by Kevin Klombies, Senior Analyst

Friday, November 23, 2007

Chart Presentation: Dancing

Nov. 22 (Bloomberg) — Japan became the first of the world’s 10 biggest stock markets to enter a bear market since the summer’s U.S. subprime-mortgage collapse after the Topix index declined 21 percent from its 2007 peak.

Nov. 22 (Bloomberg) — Japanese bonds rose, pushing the 10- year yield to the lowest in two years, as a global slump in corporate debt and equity markets prompted investors to buy government securities.

Nov. 22 (Bloomberg) — Royal Bank of Canada, Bank of Montreal and their four biggest domestic rivals may report debt writedowns totaling C$1.9 billion ($1.93 billion), contributing to the industry’s first earnings drop in five years.

We have included snippets from three Bloomberg articles published yesterday. Together they argue that Japan’s stock market is weak on both an absolute and relative basis, Japan’s bond market is on the rise, and Canada’s major banks face the first decline in earnings in five years.

At right we show a comparison between, from bottom to top, the 10-year Japanese (JGB) bond futures, Canada’s Bank of Nova Scotia (BNS), Bank of America (BAC), and Bear Stearns (BSC).

When Japan’s asset price bubble burst in 1990 bond prices began to rise as inflation turned into disinflation and eventually- in Japan- to deflation. In a world of falling interest rates those companies that borrow short-term and lend long-term tend to do very well and over time the stock prices of many of the major financials rose rather nicely. In fact the three bank charts at right are scaled in semi-log so the trend lines represent a constant and compounding rate of price appreciation.

Whether one marks the end of rising bond prices as 2003 or, perhaps, the end of 2005 is somewhat moot. The point is that the equity markets in general and the financials in particular have benefited from falling interest rates for an extended period of time and when a trend runs this long it creates an excess of excess. From exchange traded funds that allow investors to trade commodities like stocks to the advent of hedge fund billionaires and house price futures contracts just about anything and everything ‘real’ has been turned into a tradeable financial asset. Is it any wonder that every time the Fed raises interest rates for an extended period of time the markets move into a state of utter chaos? To keep the music playing and the participants dancing the only recourse is yet another round of dramatically lower interest rates.


Equity/Bond Markets

With the U.S. markets effectively closed until Monday we had a choice to make. We could take the day off and watch some football, do a shortened version of the IMRA, or we could approach this as business as usual. Unfortunately we chose the latter option and are doing a regular issue- with one minor twist. We have removed all of the charts that we have been following and monitoring on a daily basis and have in large part attempted to show and cover perspectives that we haven’t touched on for some time.

The chart at top right compares the stock price of Canada’s Magellan Aerospace (MAL on Toronto) with copper futures and the sum of the U.S. 30-year T-Bond futures and the U.S. Dollar Index (DXY) futures.

The offset to the weaker U.S. dollar is, naturally enough, strength in other currencies. While a strong currency is appreciated because it increases the wealth and purchasing power of an entire country it also does considerable damage to the export-oriented industries. Since Canada has had a weaker currency for close to 3 decades a substantial portion of its economy is based on its ability to export both raw materials and finished goods.

The point is that Canada’s aerospace industry tends to do very poorly when the Cdn dollar is stronger and the Cdn dollar is stronger when metals prices are on the rise.

The chart shows that MAL bottomed out through 1995 at the cycle peak for copper prices and the low for the combination of the dollar and long-term Treasury prices.

For as much as the current cycle is wholly unique in a great many respects it really is nothing more than a rehash of past events. Strength in commodity prices goes with strength in the Canadian dollar and this leads to weakness in the export-oriented manufacturing base. The Bank of Canada raises interest rates to cool price pressures which pushes the Cdn currency higher and then is forced to lower interest rates to avert the inevitable economic slow down or recession that follows. Nothing new here although the markets do a very nice job of making it appear that this is a one-way trend instead of a cycle.

At bottom right we show the sum of the TBond futures and the U.S. Dollar Index from 1994- 95 and 2006- 2007.

The sum began to flatten out in late 1994 as the bond market began to rise and after a few quarters of trading sideways below the moving average lines the trend turned positive in the spring of 2005. By late summer the dollar had joined the party and the sum remained in a positive trend for roughly the next seven years.

The sum of the TBonds and the DXY stopped declining this past summer and is currently chopping sideways as dollar weakness is offset by bond price strength. Once again copper prices are peaking and MAL is at its lowest price since 1995. From a macro point of view, however, the markets are doing what they need to do to create a change in trend. The charts argue that to get from ‘here’ (all things commodity) to ‘there’ (Cdn manufacturers) the dollar and bond market will have to rise in tandem as metals prices and the Cdn dollar decline.