by Kevin Klombies, Senior Analyst

Thursday, December 6, 2007

Chart Presentation: Lagged View

We return today to an argument that we have made on a number of occasions in the recent past. Below we show 3-month eurodollar futures (short-term U.S. debt prices) and the CRB Index (commodity prices) while below right is a comparison between 3-month euribor (short-term European debt prices) and the CRB Index.

The thesis is that commodity prices trail changes in interest rates by roughly two years. In other words when the Fed or ECB begins to tighten credit conditions it does so because cyclical growth is strong and rising and after a considerable lag- two years in this case- the impact of rising interest rates shows up in falling raw materials prices.

In the ‘old days’- pre-European Central Bank, that is- we could show this using U.S. interest rates or long-term Treasury prices because the rest of the world tended to swing with or follow whatever the Fed was doing. Through the recent cycle the ECB diverged markedly with the Fed as it held interest rates at the lows well after the Fed began to tighten and is doing its best to keep interest rates at the highs after the Fed has started to ease.

The charts are shifted or offset by two years to take into account the lag between debt and commodity prices. The argument is that the first top for the CRB Index in the spring of 2006 lines up with the decline in eurodollar prices in the spring of 2004 while the second top for the CRB Index late in 2007 is a reflection of the decline in European debt prices in late 2005. The bottom line is that between now and at least mid-2008 the combined impact of past increases in U.S. and European interest rates should weigh heavily on the trend for commodity prices.





Equity/Bond Markets

The trend this year has heavily favored the energy sector leading to a rather relentless rise in the ratio between the Amex Oil Index (XOI) and the Airline Index (XAL) and the XOI compared to the broad U.S. equity market (SPX).

The point is that major trends tend to change early in a new quarter or year so it would be surprising- not impossible but certainly surprising- if both ratios broke down through support this month. However, aside from that we do expect the ratios to turn lower which suggests that the energy sector will underperform through 2008.

Below we have included two comparisons between the CRB Index, the stock price of U.S. home builder Hovnanian (HOV), and JetBlue (JBLU). The chart below is from 2006 while the chart below right is from 2007.

Some time back we argued that we could make a case for going positive on the home builders but believed that this was something to think about early in 2008. Barring something unusual in the commodity sector this still seems about right. We might see the lows for the home builders this month but a positive trend is more likely to develop in January. After all, how many funds are going to want to show that they owned something like the home builders in their end-of-year portfolios?

The bottom for both JBLU and HOV was made in 2006 at or near the time when the CRB Index broke below its 200-day e.m.a. line. The chart at bottom right makes the point that commodity price weakness to date is still not sufficient enough to truly turn the trend. The closer the CRB Index gets to 300- 310 the more out interest will be piqued. The set up seems reasonable even though it appears that more time will be required to get this firmly back into place.