by Kevin Klombies, Senior Analyst

Monday, January 28, 2008

Chart Presentation: FCX/JPM

The chart at top right compares the U.S. Dollar Index (DXY) futures with the ratio between the share prices of FreePort McMoRan (FCX) and JP Morgan Chase (JPM).

This chart is based on a similar comparison that we have used in the past that featured the ratio of Phelps Dodge to JP Morgan Chase. We have included this chart on page 4 but since FCX purchased PD early in 2007 we have replaced PD with FCX.

The FCX/JPM ratio represents the markets’ broad interest in the commodity cyclical theme (FCX) versus the financial (JPM) and consumer themes. When the ratio is declining- as it was from 1995 through 2000 money is moving generally away from the commodity sector and towards the financials. When the ratio is rising the trend has reversed with money pushing the commodity theme higher to re-balance relative prices.

The arguments are that this ratio swings higher and then lower about ever six years creating the broader 13-year cycle that we have described in past issue. As well the trend for the U.S. dollar is a mirror-image of the ratio’s trend so when the commodity theme is dominant the dollar is weaker.

One of the more perplexing market reactions in recent years began in late summer last year. Our view was that when the dollar moved back towards the 80 level with the FCX/JPM back to the original starting point set in 1995 and 1996 the markets had completed the re-balancing of relative prices. Between 1995 and 2001 the theme focused on the financials, consumers, and techs along with the dollar followed by a multi-year period of dollar disdain and rising commodity prices.

The chart at bottom right compares gold futures with the stock price of Fannie Mae (FNM).

As the dollar broke below support at 80 the FCX/JPM ratio went ballistic. We can see that the dollar below 80 went with a price break out by gold futures and a concurrent collapse by the financials. After roughly 6 years of ‘catch up’ strength by the commodity stocks compared to the major financials the dollar failed to hold support, gold prices added another 200 or so points, and the financials moved right into the subprime crisis. Our expectation was that the dollar would hold at 80 and, months later, or expectation remains that the dollar will swing back up through 80 to initiate- somewhat belatedly- a return to a falling FCX/JPM ratio.




Equity/Bond Markets

At right is a chart of the U.S. 30-year T-Bond futures from 1986 and 1987 and a chart of the CRB Index from 1988 and 1989.

One of our intermarket arguments has been that there is close to a two-year lag between changes in interest rates and changes in commodity prices. For example, if interest rates were to decline to help push the economy out of recession it would take some time to work through the system until it eventually reached raw materials prices.

As simplistically as possible the idea works something like this. As economic demand for good and services weakens companies start to lay off workers, asset prices decline, inventories start to swell which leads to cuts in production, etc. Individuals reduce consumption while companies curtail capital spending leading to a reduction in the demand for credit and in response interest rates begin to decline.

The Fed attempts to stimulate the economy by lowering short-term interest rates. Investors having sold assets to return to cash find that short-term yields are now less attractive so money starts to push outward in terms of duration in the search for higher returns. As 1-year and then 5-year and then 30-year interest rates decline money begins to move back into higher yielding equities. Once interest rate sensitive sectors have risen money pushes out to ever more risky sectors as consumer confidence increases and corporations begin to ramp up production to meet increasing demand and re-build inventories which leads to rising demand for raw materials and stronger commodity prices.

The point is that there is a lag between changes in interest rates and the impact on commodity prices and over time we have argued that this lag is close to two years.

Bond prices tumbled during the first three quarters of 1987 and eventually the stock market collapsed. We tend to call this a ‘liquidity-inspired’ correction because it had more to do with the bond market than the real economy. In terms of our argument the sharp rise in interest rates in 1987 wouldn’t show up in the commodity markets until some time in 1989 so the charts have been set up to show the declining trend for bond prices in 1987 and the weakness in the CRB Index in 1989 that helped lead into the 1991 recession.

At bottom right we have included charts of the TBond futures from 1998 to the present day and the CRB Index from 2000 to the present day. Once again the charts have been shifted or offset by two years.

We used this exact argument to call the swings in the CRB Index between 1998 and the end of 2001 and in 2001 we repeatedly suggested that we were looking for a recovery in the CRB Index around the end of the year. We will now conveniently ignore the fact that we were looking for a commodity markets peak in 2005 later revised to the spring of 2006 and return to the point that we have been trying all along to make.

We can justify a basic flat trend for the CRB Index from 2004 forwards in response to the long flat trend for the TBond futures that dates back into 2002 but that is about it. The CRB Index can spike higher with copper and then push upwards again with the grains but ideally we should see commodity price weakness through into mid-2009. If the TBond futures go on to new highs above 125 this year then we can make a very nice case for the next commodity ‘bull’ beginning some time around the middle of next year.