by Kevin Klombies, Senior Analyst

Monday, April 28, 2008

Chart Presentation: Decision Point

What promises to be an interesting week begins today. On Friday crude oil futures priced climbed back towards 120 following a refinery strike in Scotland, dwindling supplies from Nigeria, and warning shots from a ship carrying U.S. cargo at Iranian boats. Microsoft disappointed the markets with earnings while the S&P 500 Index futures ran into solid resistance at the 1400 level. To top it all off the dollar ended better as the markets began to discount either no rate change from the Fed this week or a final 25 basis point cut to 2.0%.

We can’t recall the last time we didn’t feel as if the markets were at a major decision point but, even so, that is exactly how things appear at present. To explain what we mean we have included a chart of the S&P 500 Index (SPX) from 1987 at top right and a chart of gold futures from the current time frame at bottom right.

In 1987 the SPX made two almost identical ‘tops’. The first top proved to be a mid-cycle consolidation as prices declined to the correction lows in late May before pivoting higher and moving on another 20% to the August highs.

Using the MACD indicator we can see that through into October of 1987 the equity markets rallied each time the technical conditions became slightly ‘over sold’. In other words in a strong and rising trend a market can get significantly ‘over bought’ and then will find support on minor levels of ‘over sold’. We mention this because this is a point that we will return to on page 3 today.

The gold futures chart today appears quite similar to the SPX from 1987. After peaking in mid-March gold futures prices declined sharply into the start of April with the MACD indicator moving to a low and then rallied back towards 950 as conditioned buyers returned to buy the dip. Fair enough. The problem- perhaps- is that similar to both May and October of 1987 gold prices have swung right back to the lows along with the MACD indicator.

Our point is that downward pressure on gold is coming from strength in the dollar and strength in the dollar is coming from upward pressure on U.S. short-term interest rates as the credit crisis eases. Gold futures have returned to support and to a level of ‘over sold’ that has recently brought in buyers. The 1987 example suggests that we have reached a decision point that could lead to gold prices returning to 650 or moving on towards 1100 this summer.



Equity/Bond Markets

On Friday we showed that the U.S. equity markets have been running hard from theme to theme. Most of the action has been focused in the commodity sectors but given the right set of circumstances it is possible to see a few months of strength in some of the non-commodity names. We pointed out that AMR’s stock price had doubled in late 2006 before the equity markets rotated back to the energy theme and then mentioned in passing that we liked names such as Intel as well as the broader tech and telecom sector. Now for a quick explanation.

Below we show AMR, the ratio between the Amex Oil Index (XOI) and the S&P 500 Index (SPX), and crude oil futures from 2006.

Around the time that copper prices peaked in 2006 the markets began to shift back towards strength in some of the more defensive names- including pharma- while crude oil prices continued to climb. By the summer of 2006 with crude oil prices pushing above 75 the XOI/SPX made a peak as AMR’s stock price bottomed. The chart at top right shows, however, that AMR’s stock price bottomed back in late 2004.

When crude oil futures and the XOI/SPX ratio broke back below the 200-day e.m.a. line at the start of September in 2006 the correction low for AMR was made leading to a doubling of the share price into the first quarter of 2007.

Our thought is that if oil prices and the XOI/SPX ratio finally weaken to the point where they break back below the moving average line then we should be looking for one or more sectors that have experienced sharp corrections after turning positive roughly 5 to 6 quarters previous. In other words our ‘guess’ was predicated on the observation that telecom names such as Deutsche Tel and even Cisco have similar charts today to AMR back in the autumn of 2006.