by Kevin Klombies, Senior Analyst

Friday, June 27, 2008

Chart Presentation: Encouraging

We have written on occasion that we didn’t think that the equity market’s correction had fully run it’s course and that we expected the S&P 500 Index to make bottom between 1280 and 1290. By closing yesterday at 1283.15 in the face of additional bond markets strength a tentative case can be made that a bottom is within reach. Of course all bets are out the window if crude oil prices continue to spike higher.

At top right we show a comparative view of the ratio between the Morgan Stanley Consumer Index and the Morgan Stanley Cyclical Index (consumer/cyclical) as well as the ratio between the pharma etf (PPH) to the share price of Caterpillar (CAT).

The argument is that this is the third time since 2006 that the equity markets have swung from relative strength in the cyclicals back to strength in the consumer defensives. Similar trend changes occurred in mid-2006 and 2007 and we will use these time frames for our work on the following page.

Below we show copper futures and the consumer/cyclical ratio.

The point is that when the equity markets make an internal shift back towards strength in the consumer stocks it is supposed to mark the peak for copper prices. We have argued in the past that when copper prices turn lower this is a leading indicator of weakness in crude oil prices.

The problem is that each time we get even a bit of weakness in copper prices the dollar begins to weaken and money pours back into the commodity sector as the major banks and financials move back under pressure.

We are not arguing that this time is different but are merely suggesting that it has proven to be a very slow process. At the bottom for the consumer/cyclical index (which was reached in mid-May) we should start to see general downward pressure on base metals prices and a concurrent lift on bond prices. The equity markets tend to move to the down side as the cyclical stocks weaken but then are supported by a rising trend for the consumer, pharma, and financials. At present the markets are stuck within the trend change as the cyclicals decline even as the defensive sectors move lower. However, to the extent that this process was always going to pull the S&P 500 Index back below the 1300 level we can argue that in some respects yesterday was actually quite encouraging.




Equity/Bond Markets

Below we show three charts of the S&P 500 Index. The time frames are based on the upward pivots in the consumer/cyclical ratios shown on page 1.

To quickly recap- the SPX tends to decline when the consumer/cyclical ratio turns higher. The bottom for the consumer/cyclical ratio tends to mark the start of downward pressure for copper prices. Copper prices turn lower in advance of crude oil prices. In a perfect world the ratio bottoms and copper peaks. Copper prices then decline as the equity markets remain under pressure and then crude oil prices peak which marks the bottom for the equity markets. A few weeks before crude oil hits a top the bond market begins to rally. So far, so good.

In terms of both time and price the current decline in the SPX is very similar to those of 2006 and 2007. The key- as always- rests with crude oil prices. If crude oil spikes upwards through the end of the quarter then the equity markets will remain under pressure. However… notice on page 4 that the crude oil/TBonds ratio and the Amex Oil Index/S&P 500 Index ratio have both held just below the recent highs which argues in turn that the equity markets could be very close to the correction lows.

In terms of a recovery- if, as, or when one begins- we have included two charts of the pharma etf (PPH) and airline AMR below. The chart below right is from 2006 while the chart below is from the present time frame.

The markets do not have to repeat past behavior exactly but this is generally what we have been looking for. Notice that in 2006 the pharma etf bottomed through the end of the second quarter and then began to lift in July. Crude oil prices did not peak until August and as crude oil prices broke below the 200-day e.m.a. line in early September the share price of AMR began to recover. In other words defensive sectors like pharma led the recovery by a couple of months with more cyclical names showing strength after crude oil prices had clearly turned to the down side. The problem today is that the pharma sector continues to bump along the recent lows.