by Kevin Klombies, Senior Analyst

Tuesday, November 13, 2007

Chart Presentation: Intermarkets

Wal Mart (WMT) reports fiscal 3rd quarter earnings before the bell today. Same store sales have declined sequentially from August through October although are still positive on a year-over-year basis. The expectation is that WMT will earn between 66 and 69 cents per share with most forecasts clustered around the 67- 68 range.

Aside from the fact that we rarely comment on such mundane things as earnings and fundamentals we thought we would preface our comments today with the observation that between now and the opening of trading WMT’s stock price could change substantially.

From a fundamental point of view being long a retailer as the U.S. economy balances on the edge of recession likely makes little sense. After all falling real estate prices and rising gasoline prices are hardly the back drop that would encourage U.S. consumers to get out there and spend, spend, spend. From an intermarket stand point, however, WMT has potential but only if crude oil prices are finally ready to turn lower.

The chart at top right shows the ratio between Wal Mart and the S&P 500 Index (WMT) scaled logarithmically. The very basic point is that WMT tends to strengthen on both an absolute and relative basis around the time that oil prices turn lower. Once the pivot is made the WMT/SPX ratio is capable of returning to the previous peak which would mean that even in a flat market WMT’s stock price could double from current levels. In fact, we included WMT on our page 4 list almost three years ago based on the argument that while it tends to lag at the start of the large cap and consumer cycle it does have the potential to double in price (eventually).

Below right we show Johnson and Johnson (JNJ) and copper futures.

The consumer and health care theme tends to turn positive around the time that copper prices peak. For many stocks (Coke, Merck, Schering Plough, etc.) the trend turned north back in early 2006 after copper prices nipped just over 4.00.

JNJ has struggled below the 70 level since early 2005. Our sense was that this ‘struggle’ reflected in part the uncertain trend for energy and metals prices. If copper and crude oil have finally turned lower then we would expect to see new highs for JNJ over the next few months.



Equity/Bond Markets

We are going to return to a chart that we included yesterday. At right we show the U.S. 30-year T-Bond futures and the sum of 3-month Eurodollar futures and the Fed funds target rate.

The chart makes the case that every few years the bond market reaches a price peak concurrent with the sum of Eurodollars and the funds rate- using two moving average lines (50-day and 100-day e.m.a.) moving above 100. Fine… but what does that mean?

The point is that a peak or top for fixed income prices tends to occur when the Fed is ‘slow’ to respond to slowing growth. The longer the Fed fusses and worries about the potential for inflation while holding the funds rate flat the farther fixed income prices will rise as the markets attempt to do the Fed’s work.

Typically yields on 3-month Eurodollars will be higher than the funds rate and at present the yield of around 4.85% (taken from the front month futures contract price) exceeds the 4.5% funds rate. To trigger a ‘sell’ signal for this chart markets-determined yields have to decline far enough below the funds rate so that the two moving average lines rise above 100. While this doesn’t mean that the TBond futures have to rise in price it does suggest that there really hasn’t been a clear ‘top’ for the bond market since mid-2003 and if the TBond futures break above the 115 level the rally could easily extend all the way up to 125.

The chart below right compares gold futures with the 3-year percentage Rate of Change indicator for the sum of the TBond futures and the DJ AIG Commodity Index.

Gold is unusual in that it is part ‘money’ and part ‘commodity’. Gold serves as a portable store of value and is traditionally viewed as a haven in times of crisis or obvious fiat currency debasement. On the other hand it is also a basic raw material whose value is based predominantly on supply and demand.

We like to use gold in our work because it serves as a link between markets. We often argue that gold will rise or fall relative to base metals prices depending on the trend for short-term interest rates. Our lack of interest in gold (i.e. negative and obviously incorrect view) was based almost entirely on our extremely negative view on copper futures prices. In other words while we expected the gold/copper ratio to rise we thought it would do so because copper prices were weaker.

The comparison at right has served us well for a great many years. The idea is/was that by combining the trend for the price of money (TBond prices) with the trend for commodities (DJ AIG Commodity Index) we could come up with a surrogate for the trend for gold prices. After some trial and error we settled on a 3-year %age ROC indicator for the sum of the TBonds and commodity prices.

The idea then was that when the ROC bottomed and turned higher it indicated a rising trend for gold and when it peaked and turned lower the intermarket back drop for gold was now negative. The twist or detail that we have pointed out on a few occasions over the last number of months was that the change in trend had to be confirmed by the dollar. The ROC turned positive back in 1999- 2000 but the dollar did not turn lower until the end of 2001- at which time gold prices began to rise. The ROC turned negative in 2005- 06 but the strength in gold prices suggested that the dollar had not reached a bottom… although that may well have occurred yesterday.