by Kevin Klombies, Senior Analyst

Monday, August 13, 2007

Chart Presentation: Holding the Line

We suppose that one could call this a ‘bear’ market given that the share price of Bear Stearns has fallen by close to 40% this year. Our antipathy towards banks in general and investment banks in particular is based on the observation that the combination of a trend, leverage, and greed inevitably ends in some form of crisis. The good news is that while the Fed is typically ambivalent to the plight of farmers it cares very deeply about the health of the banks and, by extension, the financial system. Each notch lower for Bear Stearns brings us just that much closer to a monetary policy rescue.

Aside from that the markets ended the week in reasonable shape. Shaken, bruised, and somewhat bent but not broken. That, at least, is something to be thankful for.

The chart at top compares the S&P 500 Index (SPX) with the product of the U.S. 30-year T-Bond futures times the Japanese yen. The idea once again is that sharp equity markets declines typically go with a rapid rise in Treasury prices and, as was the case earlier this year and back in 1998, with an increase in the value of the yen.

Our argument has been that as long as the TBonds times yen combination holds below the recent peak- and that was most certainly the case through Friday- then the equity markets are working hard to make a bottom. A quick and not necessarily accurate count places this as the eighth time since early 2003 that the SPX has thundered down towards the 200-day e.m.a. line and on the previous seven occasions the correction was just that- a correction in a rising trend.

Through much of the first half of 2006 we used the ratio of crude oil futures prices to the TBond futures as a way to gauge the trend of the SPX. The idea originated from the last pre-real estate and banking system collapse in 1990 (with the recession coming in 1991 well after the equity markets turned higher) when the bottom for the SPX was reached at the peak for the ratio of oil to bond prices.

The crude oil/TBonds ratio peaked in the summer of 2006 as the SPX floundered down around the moving average lines. The equity markets picked up positive momentum once crude oil prices began to weaken in August and from there it was up, up, and away. The chart shows that the set up this month is quite similar to last summer with the major difference being that a year ago the subprime chickens had not come home to roost. Still, the chart offers at least the prospect of a happy ending.



Equity/Bond Markets

If we were OPEC (and, thank goodness, we aren’t) we would be flooding the markets with every barrel of oil that we could produce. Why? Because the longer oil prices stay ‘high’ the greater the chances that in due course OPEC will become largely irrelevant. On the one hand this cycle has allowed billions of dollars to be committed to the Canadian oil sands and opened up the far vaster potential of U.S. oil shale and on the other hand auto companies like General Motors are pushing rapidly ahead with automobiles powered by rechargeable lithium batteries.

In any event… the real estate debacle makes the case that given enough time (and excess) all trends revert to cycles. The smart companies load up on cash when the financing window is open and the unfortunate companies load up on debt in the belief that the window will never close. And then it does.

The stock price of GM tends to trend inversely to commodity prices. Lower commodity prices (and a reasonable markets environment) should be a positive for GM into 2008.

Below is a chart of the sum of the Nasdaq 100 Index (NDX) and copper futures (copper in cents and multiplied by 12 times) compared to the ratio of the pharma etf (PPH) to the SPX. The quick point here is that when the cyclical trend turns negative typically copper and ‘tech’ decline while the health care theme (PPH) begins to show relative strength. One of the challenges of the current market has to be the fact that it feels as if the economy is falling apart but the markets are still trading as if the cyclical trend was very much alive and well. China, we suppose.

With that in mind (the cyclical trend) we shift to the two charts at middle and bottom. For as unique as the markets may feel at present they aren’t that much different than 2003. When the CRB Index reached a peak in early 2003 the stock price of Intel (INTC) began to rise. The cyclical sectors often ‘take turns’ ratcheting higher during a bull run. Through the rally INTC’s corrections always held at the rising 50-day e.m.a. line (which is basically what is happening this year) and this continued until the CRB Index finally broke to new highs at the end of 2003. For as strange as it may seem this is one of the simplest explanations for what is going on in the markets at present. A strong cyclical trend, a flat commodity market, strength rotating into the Nasdaq, and little in the way of strength in the defensive sectors.