by Kevin Klombies, Senior Analyst TraderPlanet.com
Tuesday, October 2, 2007
Chart Presentation: Follow the Money
We tend to view the foreign exchange markets as the doors with which capital must pass through as it moves from sector to sector and region to region in search of the highest potential returns. As capital shifts from theme to theme it leaves behind a clear trail of bread crumbs through its impact on exchange rates. To trade with the trend- which typically makes quite a bit of sense- one simply has to follow the money.
The chart at top right compares the Japanese yen futures with the ratio between the Nikkei 225 Index and the S&P 500 Index from 1983 through 1990.
The argument is that through much of the 1980’s the dominant theme was Japanese growth culminating in early 1990 with a massive peak for the Japanese equity market. The flow of capital towards Japan gained momentum around 1985 as it pushed the yen higher against the dollar.
From a foreign or non-Japaneseinvestors point of view the Nikkei was an excellent place to be during this time period as the Japanesestock marketoutperformed the U.S. equity markets even as the yen gained against the dollar. This is the hall mark of a dominant theme.
Below right we show the Canadian dollar futures and the ratio between the Canadian and U.S. equity markets (S&P/TSX Comp. divided by the S&P 500 Index).
For much of this decade the trend has featured a rising Canadian dollar and outperformance by theCanadian stock marketproviding foreign or non-Canadian investors with the same double-barreled returns that were found in Japan two decades earlier. The basic market theme has been small cap, non-U.S., and commodity which has fit in nicely with both the Canadian equity market and currency.
In 1988 the Nikkei/SPX ratio reached a peak as the yen finally began to top. Even though the Nikkei would not reach a final top until the end of 1989 the turn lower by the yen provided an early warning signal that capital flows were starting to shift away from Japan in search of better opportunities elsewhere. The situation was remarkably similar for both the Canadian dollar and the equity markets ratio during 2006 and if the Can dollar had slowly worked back towards .8000 into 2008 instead of extending the trend to new highs we would very likely be finding ways to compare this market now to the Nikkei going into 1990.
Below we show a comparison between the ratio between the S&P 500 Index (SPX) and the DJ AIG Commodity Index (DJCI) and the ratio betweenJP Morgan Chase(JPM) and Phelps Dodge (PD). The JPM/PD ratio only runs up to March of this year because that is when PD was taken over by FreePort McMoRan.
Our view is that over time the markets take one major asset class higher in price and then slowly shift over to lever up those sectors that were left behind. Typically the trend starts with the U.S. large caps led by the financials and consumers and then gradually rotates into the foreign markets and commodities sectors. In other words at the beginning of the process the markets levered JPM upwards as the U.S. dollar strengthened and interest rates declined and then shifted back tostocks like PD so that the JPM/PD ratio returned to its original starting point.
When the JPM/PD ratio is rising it means that equities are stronger that commodities so the SPX/DJCI ratio is another way of looking at the relative strength between JPM and PD.
In the past we have also used stocks such as Schering Plough (SGP) as a surrogate for the equity/commodity ratio and, as the chart below right suggests, we could also use large cap consumer names like Coke (KO).
The point is that the equity/commodity ratio turned higher in mid-2006 along with stocks like Coke and Schering Plough. For as much as the trend still seems to be dominated by ‘all things commodity’ a reasonable case can be made that a new trend actually began well over a year ago. The only problem is that it is very hard to see given the daily decline in the U.S. dollar against currencies like the Canadian and Australian dollars.
Below we show a comparison between Micron (MU) and Japan’s Mitsubishi UFJ (MTU). The quick point is that the spring of 2003 and again in mid-2005 the market’s trend shifted so that both of these stocks became positive. If history were to repeat then the autumn of 2007 would be an appropriate time for the trend to return to positive into the first half of 2008. We mention this because Micron is set to release its 4th quarter earnings today.