by Kevin Klombies, Senior Analyst TraderPlanet.com

Monday, November 12, 2007

Chart Presentation: Divergence

The argument is that a bull market starts when the bond market begins to rise. At times cyclical weakness will pull the broad equity markets indices lower for some length of time but in general when bond prices turn upwards it marks the start of a positive trend for equities.

A notable exception might be the time span between 2000 and 2002 when the bond market lifted even as the S&P 500 Index and NASDAQ declined but even as the large cap tech and telecom stocks moved lower many other sectors- notably the home builders, pipelines, utilities, and many of the financials- turned higher. We have commented in the past that one usually wants to be long those sectors that are causing interest rates to rise and not long (or short) those sectors that are making interest rates decline.

The chart at right compares the Canadian dollar futures, the CRB Index, and the ratio between Caterpillar (CAT) and Coca Cola (KO).

We have been focusing on this general relationship for some time now. The idea is that CAT represents cyclical economic strength while KO tends to represent steady and more defensive growth. When the equity markets bid the stock price of CAT higher relative to KO it means that there is an overall positive or bullish view on domestic and international growth while when KO is stronger it tends to reflect a more uncertain or cyclically negative back drop. At times both stocks can rise or fall in tandem but the ratio simply reflects which is the stronger theme.

The charts are set up to create a ‘picture’ that represents our view of what ‘the markets’ are saying about current conditions. The most obvious detail would have to be the marked (i.e. huge) divergence between the CAT/KO ratio (which has been declining steadily since July) and the overwhelming strength of commodity prices (CRB Index) and the commodity currencies (Cdn dollar).

In a sense the markets are either completely confused about the health of global economic conditions, anticipating a decline in commodity prices some time out in the futures, or trading as if the strength in commodity prices is the cause and not the result of future economic weakness. Our view is that this has almost everything to do with crude oil futures price strength. Oil prices have continued to rise long after we would have expected them to turn lower. This has intensified the negative pressure on the financial sector and delayed the recovery in the non-energy cyclicals. Week after week and month after month we have observed that once oil prices begin to trend lower the equity markets should do better but as usual the key issue remains ‘when’ that will be.

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Equity/Bond Markets

We are going to show something a bit different here today. At right we have included a comparison between the Euro futures and the price spread or difference between 3-month European debt (euribor futures) and 3-month U.S. debt (Eurodollar futures).

The charts have been offset or shifted by approximately 5 quarters or 15 months. The idea is that since the inception of the Euro in 1998 the price spread between European and U.S. short-term debt has ‘lagged’ the trend of the Euro by more than a year. When the spread is high it means that European debt prices are higher than U.S. debt prices. Another way of viewing this would be to say that when the spread is ‘high’ European short-term interest rates are ‘low’.

At a level of +2 European short-term yields would be 2% less than U.S. yields and at -2 U.S. yields would be 2% lower.

The point is that if the currency is leading the change in relative interest rates then the direction of the Euro gives us an insight into the future. By this we mean that if the Euro is strong and rising- as it has been since early 2006- the spread line should resolve higher. Since it does this through a decline in European interest rates or rise in U.S. yields next year- 2008- should be dominated by a trend that forces U.S. yields higher or European yields lower so that the spread which is currently rushing towards ‘0’ returns to more than 2%. Either the Fed gives up on trying to save the real estate market and the financials and returns to fighting inflation as U.S. yields rise towards 6% or the ECB stops worrying about inflation and pulls European rates down towards 2%. We suspect that the trend for crude oil prices will dictate which scenario comes to pass.

Quickly… at bottom right we show one of our favorite bond market indicators. Tops for Treasury prices tend to occur when the sum of the funds rate and 3-month Eurodollar futures pushes above 100. At present there is still a good possibility of something close to 125 for the TBonds next year. Quickly once again… when CAT is on the moving average line the sum of copper and crude oil tends to be at or near its line. Still looks like 10% or greater down side risk for metals and energy prices.

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