by Kevin Klombies, Senior Analyst TraderPlanet.com
Friday, July 27, 2007
Chart Presentation: Equities/Commodities
When the markets get as volatile as they have been this week we tend to take a big step back in search of perspective. It has been our experience that any time we make a markets decision based on emotion- either fear or greed- we would have been better off doing the exact opposite.
If we have a BIG view it is likely the one shown on the chart at right of the stock price of Schering Plough (SGP) and the ratio of equities (S&P 500 Index) to commodities (DJ AIG Commodity Index).
The argument early last year was that at the peak for commodity prices we would reach the top for interest rates and that this would lead into a ‘drive’ by the equity markets that would last for at least twelve months. Aside from that fact that the rising trend is now roughly twelve months old… we used the term ‘at least twelve months’ on purpose because the tendency to ‘drive’ usually lasts well beyond one year. Following the pivot in early 1995, for example, the SPX held at the 200-day e.m.a. line during corrections for close to 3 1/2 years and following the pivot in 2000 the SPX’s rallies died at the 200-day e.m.a. for the next 2 years.
The ‘drive’ was supposed to be defined by a rising trend for the SPX/commodity ratio. The stock that we chose to reflect this trend was Schering Plough.
The SPX/commodity ratio turned upwards in July of 2006 and has held a very nice support line ever since. Considering the number of times this line has been tested over the last five months it makes sense to at least give it the benefit of the doubt.
The ratio closed right at support yesterday.
The basic point is that if the support line holds then either the equity markets have to strengthen or the commodity markets have to weaken. Since the key commodity sectors are energy and metals this means that we are still looking for lower oil and copper prices.
While the chart does not show the fine details suffice it to say that the SPX has had some very sharp rallies once the ratio has reached the support line. The index has managed to gain 30 or 40 points in a day or two on a number of occasions to help keep the trend intact. This time, of course, could well be different but as long as the support line holds we are inclined to be positive regarding equities.
Equity/Bond Markets
The rather messy chart (apologies) reflects something that we have been following since last year. The chart compares the CRB Index with Merrill Lynch (MER) and the July Fed funds futures.
The argument was that the markets keep trying to find a way to convince the Fed to cut the funds rate. Into the end of last year the markets sold commodities off until the Fed funds futures moved to reflect a 25 basis rate cut. When commodity prices rallied this year the financials (MER) took a turn moving lower and the Fed funds futures moved back to reflecting a 25 basis rate cut. Once commodity prices reached a peak at the end of March the financials rallied higher and the Fed funds futures moved lower.
Our view is that markets ‘want’ a cut in the Fed funds rate and you can see this in the way the yield curve keeps inverting. If commodity prices rally the financials weaken and if commodity prices weaken the financials can rally. The recent strength in crude oil and copper has left the markets only one choice- hammer the financials- and we have seen the results of that choice this week.
A number of weeks ago as the consensus seemed to view higher interest rates as a given… we argued that in each of the past three years the TBond futures had changed direction at the end of the second quarter and then pushed through the 200-day e.m.a. line by the first week in August. Yesterday’s intraday high of 110.125 simply meant that the bonds got there a bit earlier than expected. In hind sight we should have spent more time on what would have to happen to get the bonds to rally that far that fast since it was going to require either a melt down in commodity prices or a sense of impending doom in the credit markets.
We return to an argument that we made on a number of occasions last year. The idea was that when the Fed cuts the funds rate it marks the start of a positive trend for two stocks- Boston Scientific (BSX) and Lear (LEA). Since LEA was the subject of a take over offer (since rejected) we dropped the idea but now that LEA is breaking lower we will likely do this one more often. All that we are missing is the first cut by the Fed in the funds rate.
