by Kevin Klombies, Senior Analyst, TraderPlanet.com
The markets are too humbling , we are wrong (although we tend to be believe that we are early instead of wrong in most instances) too often, and the work that we do is too macro for us to spend much time indulging in gratuitous self back-patting. The point? We spent most of last week arguing that cyclical equity market declines into the month of October tend to bottom out around October 10th. As such we expected that the sell off in the equity markets would run its course by the end of last week and as of today that appears to be one of our better calls. We will leave it at that and move on.
We have spent quite a bit of time and space working on either the share price of Coca Cola or the ratio of Coke to the S&P 500 Index. As usual the arguments have less to do with KO and more to do with trying to sort out the underlying equity markets theme or trend.
At top right we show a comparison between the ratio of the CRB Index and the SPX and the ratio between Coca Cola (KO) and the SPX from 1993 into 1997. Below right we show the same comparison from early 2005 forward.
The top chart does a nice job of showing how this is supposed to work. When the KO/SPX ratio began to rise in May of 2004 the CRB/SPX ratio turned lower. When consumer stocks such as Coca Cola begin to rise relative to the broad market then typically this goes with relative weakness in the commodity markets. Fair enough.
When we view the current chart we can see- hopefully- why the markets have been so challenging over the past couple of years. The KO/SPX ratio turned higher in May of 2006 as the CRB Index began to weaken relative to the broad U.S. equity market. Then… even as the KO/SPX ratio marched upward the commodity markets began to recover.
The point is that one of these ratios is ‘wrong’. Either the KO/SPX ratio is in a rising trend suggesting that commodities are far too high relative to equities or… the CRB/SPX ratio is correct suggesting that the consumer, financial, and health care sectors are at major risk.
We have included a shorter-term view of this chart on page 5 today. While there are no clear winners in this titanic intermarket tug of war as of yet we continue to believe that the KO/SPX ratio will eventually prove to be the dominant positive trend.
Second chart below is a comparison between the S&P 500 Index and the ratio between the Morgan Stanley Consumer Index and Morgan Stanley Cyclical Index. The consumer index includes such names as Abbott Labs, Merck, Coca Cola, Gillette, Pepsi, Wal Mart, etc. while the cyclical index consists of companies like Alcoa, Caterpillar, Ingersol Rand, Citigroup, FreePort McMoRan, Ford, etc.
The chart shows that over the past number of years the trend for the SPX has been set by the relative performance between the cyclical and consumer sectors. When the cyclicals are stronger the markets rise and when the consumers are stronger- as they have been since mid-2007- the trend for the SPX is negative.
If we only used this time frame the conclusion would be that an equity bull market simply has to be driven by strong cyclical growth but that isn’t the case. It most certainly can be driven by strong cyclical growth but there have been extended periods of time in the past where the opposite was actually true.
At bottom right we show the same chart comparison from 1993 into 1997. The three-year equity bull market from the spring of 1994 into 1997 was clearly driven by strength in the consumer sector.
The point? Ideally we would like to see the equity markets rise based on strength in the consumer sector but for that to happen the pharma sector will have to rise to the occasion. If there is one thing missing from our perspective it is a true ‘driver’ behind a better consumer trend.
Below we have included a chart that we used in yesterday’s issue. The chart shows the U.S 30-year T-Bond futures and the CRB Index. The basic point is that the bond market tends to lead the commodity markets by roughly two years so in this example the rising trend for long-term Treasury prices in 1984 preceded the commodity market’s rally in 1986 while the pre-crash decline in bond prices in 1987 forecast the end of the positive cycle for commodity prices into 1989.