by Kevin Klombies, Senior Analyst,

In a perfect world the S&P 500 Index has already passed through its momentum bottom (October 10th) and its correction lows (October 27th) and is ten days to two weeks away from swinging back to the upside on the way towards 1200.

Obviously this is anything but a perfect world and even in this very rosy scenario there is room for a retest of the lows into next week but, all things considered, things could be worse.

We have argued over time that there are two distinctly different bond markets scenarios that could lead to renewed strength for equities. The first would come from falling bond prices and rising yields as the markets begin to discount the potential for stronger cyclical growth than currently anticipated.

The second and, we suspect, more likely outcome would depend on stronger bond prices. Sort of a replay of 1982.

At top right we show the SPX, 3-month eurodollar futures, and the U.S. 30-year T-Bond futures from 1982. The S&P 500 Index declined to new lows into August but… only after both 3-month eurodollar futures and 30-year T-Bond futures had begun to surge in price. In other words the trend for financial asset prices turned positive at the start of the third quarter in 1982 even though the stock market made new lows before snapping to the upside.

Is today in any way similar to 1982? We believe that it is.

The chart at bottom right shows that early in the fourth quarter of this year the trend for 3-month eurodollar futures turned higher. The T-Bond futures made two tests of support around the 113 level before swinging higher and ended yesterday’s session with decent gains after a rocky start.

The argument is that the equity markets may require a ‘trigger’ of sorts to turn positive and in 1982 this was accomplished through bond market price strength. In the little fantasy world that we are constructing the bond market manages to resolve higher through this week’s refunding with the 2-year and 5-year U.S. Treasury futures moving to new highs for the year followed by the 30-year T-Bonds pushing on towards and then through 123.



Equity/Bond Markets

One definition of insanity is repeating a behavior while expecting a different outcome. We mention this because we are going to return to the U.S. autos today.

The chart at right compares, from top to bottom, the ratio between the oils (XOI) and the broad market (SPX), the sum of the share prices of Ford (F) and General Motors (GM), and the cross rate between the Japanese yen (JPY) and Canadian dollar (CAD).

The trend turned negative for the autos in 1998- 99 concurrent with the peak for the yen relative to the Cdn dollar and the low point for the oils relative to the broad U.S. stock market. The point is that as long as these two relationships do not change… it makes no sense to even entertain the notion of turning positive on the auto stocks. Especially given that both GM and F appear to heading rather rapidly towards zero.

Our point, however, is that the ‘negative trend drivers’ that have buried the autos appear to be changing. The yen has turned higher against the Cdn dollar while the oils have (rather marginally to date) begun to weaken relative to the S&P 500 Index. So… it would be insane of us to argue in favor of the autos if nothing had changed but that no longer appears to be the case.

Quickly… we have argued that when the bond market (TBonds) and the dollar (U.S. Dollar Index) are both trending higher then one should focus on the consumer defensives, pharma and health care sectors, and even the financials. This is why we continue to like Johnson and Johnson (chart below right) although we would obviously be happier if the stock was trading on the north side of its 200-day e.m.a. line.

Below we show Inco from 1987 and Wal Mart from today. The very quick point is that theme-wise we believe that WMT is in a positive trend in much the same way that N was in a positive trend through 1987’s stock market ‘crash’.