Chart Presentation: Defensive

One argument for why the U.S. equity market manages to avoid getting crushed by rising energy prices comes from a simple ratio. In January of 2007 the ratio of the S&P 500 Index to crude oil futures prices rose to roughly 28 times while it ended last week around 11 times. To put this into some form of perspective notice that the daily closing low for this ratio in the midst of the 1987 stock market crash was about 11.3:1. In other words U.S. large cap equities relative to crude oil prices are now back to levels associated with the complete equity markets collapse more than two decades ago.

At top right we show the sum of copper futures and crude oil futures compared to the sum of the U.S. 30-year T-Bond futures and the U.S. Dollar Index (DXY). For this example copper is valued in cents while crude oil is priced in dollars and then multiplied by three times (more on this on page 3 today).

The argument is that the dollar and long-term Treasury prices are on one side of the equation with energy and metals prices on the other. In general the offset to falling bond prices and the dollar is a rise in commodity prices while weakness in commodity prices will tend to go with either a stronger dollar, stronger bond prices, or some combination of the two.

The peak for the sum of copper and crude oil prices in May of 2006 went with the low for the sum of the TBond futures plus the DXY.

Aside from pointing out something that we have done in past issues our intent is to focus on the short-term position of the combination of the TBonds and DXY. We have included this comparison at bottom right.

While crude oil futures prices continued to drive higher last week a sharp rise in exchange inventories led to offsetting weakness in copper prices which, when all was said and done, left the sum of the two just below the April highs. On the other hand the long end of the Treasury market rose in price towards the end of the week even as the dollar began to weaken to leave this combination not only above the April lows but very close to a potential trend change.

The point? Even as the credit markets crisis raged the markets were bidding up the prices of cyclical assets ranging from commodities to the home builders on the hope that Fed easing would save the day. By last week, however, it felt as if money was starting to move back towards some of the more defensive sectors.

To put the markets into some form of perspective we show heating oil futures from 1989 to the present day at right.

In the spring of 2004 we were arguing that the Fed was holding the funds rate too low for too long and that the markets would force the Fed to raise rates by driving energy prices higher. Notice on the chart that by roughly mid-2004 heating oil futures finally broke to new highs.

At bottom right we show a comparison between lumber futures, the stock price of Canada’s Canfor (CFP on Toronto), U.S. home builder Beazer (BZR), and Bear Stearns (BSC).

As heating oil futures moved above the highs set in 1981, 1990, and 2000 in the late summer of 2004 we can see that lumber prices turned lower. Roughly six months after lumber prices began to decline the trend for forestry products stocks such as Canfor turned negative and six to 12 months after the forestry sector rolled over we began to see the first indications of weakness in the home builders. Eventually those financials levered to real estate prices began to weaken which, some time later, escalated into a veritable crisis.

The point is that it was the upside break out by energy prices in 2004 that really started the ball rolling. This capped the rally in lumber prices which fed into the forestry sector and then into the home builders. Weakness in housing prices then led into a financial and banking system crisis. While weaker energy prices would obviously be a positive for many sectors at minimum we would like to see lumber futures prices start to rise followed by a recovery in the forest products sector before we get overly enthusiastic about the prospects for the home builders and real estate markets.

Quickly… Potash Corp. has been a relative strength leader in the commodity sector and has recently been rising with crude oil prices after making a short-term bottom at the end of April. If POT were to turn lower this week our argument would be that this would be a negative for crude oil prices.