by Kevin Klombies, Senior Analyst,

We are going to attempt to show exactly what went ‘right’ yesterday leading to a nice intraday recovery for the U.S. equity markets.

The chart at top right compares the yield index for 10-year U.S. Treasuries (TNX) with the ratio between the CRB Index (commodities) and the S&P 500 Index (U.S. large cap equities).

One of our views has been that commodity prices have to decline relative to equity prices. After all… if we are going into a global recession financial asset prices should most certainly rise relative to hard asset prices.

Problems began in mid-September when Lehman went into bankruptcy and extended through last week when Lehman’s debt was auctioned off and the outstanding Credit Default Swaps were settled. In the run up to last Friday no one knew how big the ultimate losses would be so, in response, the markets sold off everything with any kind of liquidity ‘just in case’. When the dust settled we understand that losses might well have been only a small fraction of what was originally feared.

In any event from mid-September through into this week financial assets- stocks and bonds- were under intense selling pressure. 10-year yields jumped from under 3.3% to close to 4.1% in the face of a slowing economy which, we will add, is somewhat unusual. Yesterday 10-year yields began to decline which indicated that selling pressure was abating which then led to a zippy stock market recovery.

We have argued on occasion that we believe the U.S. equity market should serve as a sort of global ‘anchor’. In other words it should do better than most other markets. The problem has been that while the S&P 500 Index has been relatively strong… it has also been absolutely weak. When the anchor market is falling it puts tremendous pressure on the smaller foreign markets.

The chart at bottom right compares the CRB Index with the ratio between the Canadian (S&P/TSX Comp.) and the U.S. (SPX) equity markets. The point is that when commodity prices are falling the Cdn equity market should decline relative to the U.S. equity market. All well and fine IF the U.S. equity market is actually rising but nothing short of a disaster if the U.S. market is falling 5% on a daily basis.



Equity/Bond Markets

To continue- quickly- with the first page argument we show the CRB/SPX ratio and the share price of Coca Cola (KO) below.

If the S&P 500 Index was supposed to serve as a global equity markets ‘anchor’ then the large cap consumer and health care stocks were supposed to serve as an ‘anchor’ for the SPX. In other words a sharply declining commodity trend was supposed to move interest rates lower while pushing stocks like KO higher.

The chart shows that from Lehman’s bankruptcy through the end of last week as bond prices declined and yields rose… the stock price of KO was hit fairly hard. Why? Because it, like Johnson and Johnson, Abbott Labs, and even Treasury bonds, was liquid. It could be sold- in size- to raise money just in case.

At top right we show 3-month euribor futures and the ratio between Japan’s Mitsubishi UFJ (MTU) and gold (GLD). The argument yesterday was that one good sign of an impending and hopefully sustainable ‘turn’ would be a rising trend for MTU and downward pressure on gold prices. This was supposed to go with a turn higher for short-term European debt prices and short-term euro-zone interest rates began to finally decline. This definitely appears encouraging to us.

Below right we show 10-year Treasury yields in the ratio between Johnson and Johnson (JNJ) and the S&P 500 Index.

The JNJ/SPX ratio rises as long-term Treasury yields decline. Fair enough. The problem over the past four weeks or so has been that the ratio has been rising rapidly even as yields are pushed higher. In other words with the JNJ/SPX ratio at the highest level since early 2003 one could argue that 10-year Treasury yields close to or well below 3.5% instead of just moving back below 4.0% would be more appropriate. This is why we have been arguing almost daily that we expect the long end of the Treasury market to rise in price even as prices were falling.