Chart Presentation: Major Trend Change

We have a tendency to be early- often egregiously so- with our markets views because we are continually looking out over time in an attempt to discern what will happen ‘next’. As best we can, however, we try to be consistent so if we like or do not like something today there is a better than even chance that we will hold the exact same view tomorrow.

We mention this because we have been receiving a disconcertingly large number of emails asking us when it will be safe to return to the commodities markets. The only answer that we can give aside from ‘anywhere from two to four years from now’ would be that we will take a good hard look at it during the first half of October (chart on page 5).

The chart at right presents a comparison between the U.S. Dollar Index (DXY) futures and the ratio between the Morgan Stanley World ex. USA Index and the Dow Jones Industrial Index (DJII).

The basic point is that the dollar was in a relentless down trend from late 2001 into the middle of 2008. The markets determined that better returns could be found outside of the U.S. so concurrent with dollar weakness we can see that non-U.S. equitymarkets rose relative to the U.S. large caps found in the DJII.

The chart comparison is set up to argue that the dollar has finally broken out of its down trend. This does not mean that the DXY is going back to 120 in the foreseeable future but it does make the case that the trend largely driven by outflows of capital away from the dollar has also come to an end. In other words if foreign equity markets were the place to be during dollar weakness then they are most certainly not the place to be now that the dollar has started to recover.

The trend for the World ex-USA/USA ratio is virtually the same as the trend for commodity pricesso to argue for a return to strength for gold, copper, crude oil, or natural gasone has to hold the conviction that the dollar’s recent rally is going to fail and that foreign equity markets will continue to strengthen against the DJII. We take the other side of the trade by arguing (somewhat relentlessly) that we like the dollar and we favor U.S. non-commodity large caps. We can also make a case (page 3) for certain European equities on continued euro weakness and, if pressed, Japan’s Nikkei 225 Index.

One of our views is that once energy prices turn lower the markets will have begun the shift away from the theme driven by rising energy prices over to a theme dominated by companies that find new and innovative ways to profit from the public’s fear of higher energy prices. One of the best examples of a sector that fits into this view would be the U.S. autos. Really.

At top right we show a chart comparison between the sum of the share prices of Ford (F) and General Motors (GM) and the ratio between the price of the U.S. 30-year T-Bond futures and heating oil futures from the summer of 1981 into very early 1983.

We use the sum of F and GM to smooth out the trend somewhat. We use the ratio between the TBonds (financial assets) and heating oil (energy) to depict the direction of the trend for financial assets relative to energy prices. When the ratio is rising… that is a positive for the autos.

The TBonds/heating oil ratio bottomed in the autumn of 1981 close to 9 to 10 months ahead of the eventual bear market bottom for the SPX in August of 1982. The broad stock market recovery followed sharply lower short-term U.S.interest ratesat the end of the second quarter in 1982 and a break to new recovery highs for the TBonds.

Below we show the same comparison for the current time period. The argument would be that the longer and further the ratio rises from current levels the greater the odds that the autos will start to do better. The caveat is that to date the ratio has only rallied up to the 200-day e.m.a. line- roughly similar to August of last year- so we continue to view the autos as a theme that we are prepared to like if the intermarkets continue to improve.

Quickly… below we show the ratio between the CRB Index and the S&P 500 Index (SPX). Perhaps the most glaring flaw in our thesis that commodity prices are going lower relative to large cap U.S. equities can be seen through the position of the ratio at present. It has fallen to the 200-day e.m.a. line, bounced, and then returned to the line. Our view was that it would break support and then continue to decline back to last year’s levels but through tradinglast week it had yet to break support.