by Kevin Klombies, Senior Analyst, TraderPlanet.com
The markets are too humbling , we are wrong (although we tend to be believe that we are early instead of wrong in most instances) too often, and the work that we do is too macro for us to spend much time indulging in gratuitous self back-patting. The point? We spent most of last week arguing that cyclical equity market declines into the month of October tend to bottom out around October 10th. As such we expected that the sell off in the equity markets would run its course by the end of last week and as of today that appears to be one of our better calls. We will leave it at that and move on.
We have spent quite a bit of time and space working on either the share price of Coca Cola or the ratio of Coke to the S&P 500 Index. As usual the arguments have less to do with KO and more to do with trying to sort out the underlying equity markets theme or trend.
At top right we show a comparison between the ratio of the CRB Index and the SPX and the ratio between Coca Cola (KO) and the SPX from 1993 into 1997. Below right we show the same comparison from early 2005 forward.
The top chart does a nice job of showing how this is supposed to work. When the KO/SPX ratio began to rise in May of 2004 the CRB/SPX ratio turned lower. When consumer stocks such as Coca Cola begin to rise relative to the broad market then typically this goes with relative weakness in the commodity markets. Fair enough.
When we view the current chart we can see- hopefully- why the markets have been so challenging over the past couple of years. The KO/SPX ratio turned higher in May of 2006 as the CRB Index began to weaken relative to the broad U.S. equity market. Then… even as the KO/SPX ratio marched upward the commodity markets began to recover.
The point is that one of these ratios is ‘wrong’. Either the KO/SPX ratio is in a rising trend suggesting that commodities are far too high relative to equities or… the CRB/SPX ratio is correct suggesting that the consumer, financial, and health care sectors are at major risk.
We have included a shorter-term view of this chart on page 5 today. While there are no clear winners in this titanic intermarket tug of war as of yet we continue to believe that the KO/SPX ratio will eventually prove to be the dominant positive trend.
Below we show a chart comparison of Wells Fargo (WFC), the ratio between crude oil futures and the U.S. 30-year T-Bond futures, and the ratio between the CRB Index and S&P 500 Index from 1989 into early 1992. Below right we have included the same comparison starting in early 2007.
The point is… in 1990 the start of the equity market’s recovery out of a bear market began when Wells Fargo hit bottom in October concurrent with the peak for the crude oil/TBonds ratio and the CRB Index/S&P 500 Index ratio.
A better way to put this might be that when WFC turned upwards in the autumn of 1990 it marked the start of weakness for commodity prices relative to financial prices. The price of crude oil began to decline relative to bonds while the broader CRB Index fell relative to the SPX.
In many ways this chart describes our expectation for the current market and even after a number of false starts it is our conviction that will be the way we get from ‘here’ to ‘there’.
The current chart shows that the bottom for WFC in early July went with the peaks for the crude oil/TBond ratio and the CRB/SPX ratio. The only problem to date is the lack of weakness in the CRB/SPX ratio as it hangs around the moving average lines. However if all goes according to plan- and wouldn’t that make for a nice change- WFC should lead the equity markets higher as equities strengthen relative to commodities through at least the first half of 2009.
In terms of our BIG thesis there are two currencies that we like and two equities markets that we favor. We like the U.S. dollar and the Japanese yen and we like large cap U.S. non-commodity stocks as well as the Nikkei.
To quickly explain… below we show the Canadian dollar (CAD) futures and the ratio between the Canadian and Japanese i-shares (EWC/EWJ). If the CAD is in any way ‘real’ at or near .8500 then Japan should continue to outperform Canada as the ratio moves back down to the levels of early 2007.