by Kevin Klombies, Senior Analyst,

One of the more interesting twists that the markets throw at investors revolves around the impact from changes in interest rates. We argued last week, for example, that commodity prices tend to lag the bond market by two years. We have also noted on occasion that each recession since 1968 has been preceded by an inverted yield curve (i.e. short-term yields higher than long-term yields) so when the yield curve turned negative in the second half of 2006 it was inevitable that economic growth would eventually slow.

If you take a hammer and give yourself a good smack on the kneecap there is a good chance that your brain will connect the action with the resulting very sharp pain. The learned lesson is… if you hit your self with a hammer it is going to hurt. Fair enough.

Now consider what would happen if you hit yourself with a hammer and the pain did not show up for a month. Chances are you would be surprised and confused and wouldn’t associate the cause with the effect. That is what the markets do when they work with a lag. The tightening of credit conditions that led to an inverted yield curve slowed economic growth- as was intended- but since the yield curve has been steepening for the past 18 months investors tend to believe that today’s pain came right out of thin air. Investors also tend to forget that a wide open yield curve- as is the case at present- is the monetary equivalent to the gas pedal held flat to the mat.

Will economic activity slow further? We imagine so but keep in mind that the equity markets turn higher months before the economy hits bottom and typically a full year before corporate earnings finally swing higher.

Quickly… at right we show two charts of the U.S. Dollar Index (DXY) futures and the S&P 500 Index. The top chart is from late 1999 into early 2004 while the lower chart is from the current time frame.

We have argued on occasion that the DXY has a neutral trading range between roughly 81 and 105. When it moves above the top end of the range it is ‘too high’ and this follows a cyclical trend focused on the tech and telecom sectors. When it moves below the bottom of the range it is ‘too low’ and this follows a trend focused more on commodities. When the dollar is outside the range the equity markets turn lower and remain that way until the dollar moves back to neutral. Our argument was that SPX would bottom once the dollar pushed back into the channel. Obviously the equity markets are giving our thesis a good stress test at present.



Equity/Bond Markets

We are going to take another run at an argument that we put forward in Friday’s issue. As per usual the stranger the markets on a day-to-day basis the more likely we are to show long-term relationships.

At right are two charts of Hong Kong’s Hang Seng Index and the ratio between Wal Mart (WMT) and the S&P 500 Index (SPX).

We spent quite a bit of time arguing in favor of Wal Mart through 2007. The idea was that WMT tends to outperform the SPX when energy prices and Asian growth turn lower.

On at least one occasion (that we can recall) we suggested that the cycle into 2008 might be ‘backwards’. By this we mean that crude oil prices turned lower at the start of 1997 with the Hang Seng Index bubbling up to a peak in late summer and then crashing in October while in the recent cycle the Hang Seng turned lower late last year with crude oil prices bubbling up to a peak into July.

In any event the WMT/SPX ratio turned upwards and remains upwards. Our expectation is that the negative trend for energy prices and Asian growth will extend into the middle of next year so we also expect that WMT will continue to rise relative to the broad U.S. stock market.

Below we show a chart of Amgen (AMGN) and the U.S. Dollar Index (DXY) futures.

We have shown this chart on many occasions. The idea was that the biotech theme tends to trend with the dollar. If we take this comparison literally then AMGN should be closer to 77 than 57 at present on its way back to 85 if the DXY pushes on to our target level of 92. The point? There is enough fear and loathing in the markets at present to suggest that equity prices are a good 35% ‘too low’.