Chart Presentation: KO/SPX

It appears as if the equity markets have reached a major decision point as we start the week. After correcting back towards the January lows- a relatively normal event after an intense sell off- the equity markets are either getting set to dig in and rally for the next few weeks or break lower into the summer. If the latter proves to be the case then the U.S. 30-year T-Bond futures should break upwards through the 120 level as 10-year Treasury yields fall back below 3.45%. In this scenario (page 3) we could see crude oil prices driving towards the 150 level through the second quarter of the year. The good news would be that as oil prices peak the equity markets should begin to recover and by 2009 it still appears likely that crude oil prices will have fallen all the way back towards the low 60’s.

Below are two charts of the ratio between Coca Cola (KO) and the S&P 500 Index (SPX). The top chart shows that Coke bottomed on a relative basis towards the end of 1980 as the CRB Index peaked and turned lower.

In an interesting twist the KO/SPX ratio bottomed during the spring of 2006 following a number of market-related events including A peak in commodity prices. With commodity prices now substantially higher, however, pressure has been focused on the financials.

Our first thought is that the markets are treating the banks and brokers at present in the same manner as commodity prices through the 1981- 82 recession. The second thought is that much of the damage during the early 1980’s came from Fed chairman Paul Volcker’s attempt to fight inflation through high interest rates right through a recession. In a sense history is replaying itself as the European Central Bank and Bank of Japan refuse to follow the Fed’s lead with the ECB continually stating that it has to hold rates at current levels to offset rising inflation.

In response the markets are pushing the euro and the yen higher against the dollar which, in turn, is creating upward pressure on commodity prices which serves to validate the ECB’s position. This leads to an even stronger euro, stronger commodity prices, increased fears of inflation and so on. At present it appears most likely that the circle will finally be broken once the ECB and BOJ bend to the pressures in the market and start to reduce interest rates.

Most of today’s problems trade their roots back to early 2006. At right we show the stock price of U.S. home builder DR Horton (DHI) and short-term Japanese debt prices (3-month euroyen futures). Euroyen, similar to TBills, are priced at a discount to 100 so a price of, say, 99.9 would indicate a yield of .10%.

Warren Buffet is fond of saying that you only find out who is swimming naked when the tide goes out. In this case we might argue that we only found out which sectors were relying on the constant flow of ‘free’ Japanese credit until the cost began to rise. As short-term Japanese interest rates moved upwards from close to 0% towards .9% between the spring of 2006 and the summer of 2007 the share prices of the home builders collapsed forecasting a correction in U.S. real estate prices and an eventual problem for those financials levered to the mortgage market.

Below we compare the CRB Index from 1980 into 1983 with the share prices of Mitsubishi UFJ (MTU) and Bear Stearns (BSC) from late 2005 to the present day.

The idea is that pressure began with rising Japanese short-term interest rates in early 2006. The key, by the way, is that this led to declining long-term interest rates which, in turn, damaged Japanese bank profitability which set a declining price trend for MTU. BSC ballooned upwards into the summer of 2007 before collapsing back to the falling trend set by MTU in early 2006. At present both MTU and BSC are trading at prices very close to 50% below spring of 2006 levels (i.e. MTU down from 16 to 8 and BSC down from 140 to 70).

The argument would then be that similar to 2000 the markets began to unravel soon after the Bank of Japan began to raise interest rates because in both instances higher short-term yields led directly into falling long-term yields in both the U.S. and Japan.

The next point has to do with ‘time’ which explains why we have included a chart of the CRB Index from the early 1980’s and has much to do with the comparison on page 1 between the KO/SPX ratio through 1981 and 1982 and the same ratio from early 2006 forward.

The equity market bottomed in August of 1982 as the CRB Index finally reached a low between August and October. As the equity markets rallied the CRB Index held flat before eventually turning higher later in the year and retracing just over 50% of the post- 1980 losses into the autumn of 1983.

If the current correction began with falling Japanese short-term debt PRICES and a negative trend for both the home builders and the financials then the correction is close to 2 years old which is roughly the same duration as the bear market from the peak in the CRB Index in late 1980 and the eventual bottom during the late summer of 1982.

Our thought is that if the current crisis began with rising Japanese interest rates it might come to an end once Japanese yields move back towards 0% and the easiest way to convince the Bank of Japan to cut the overnight rate would be to drive the yen substantially higher against the dollar.