by Kevin Klombies, Senior Analyst

Monday, March 24, 2008

Chart Presentation: Major Trend Changes

The chart below compares, from top to bottom, the U.S. Dollar Index (DXY- trade weighted index of the dollar against the euro, Swiss franc, British pound, Cdn dollar, Japanese yen, and Swedish krona), the ratio between the share price of copper miner FreePort McMoRan (FCX) and JP MorganChase (JPM), and price ratio between copper miner Phelps Dodge (PD- bought by FCX last year) and JPM.

The chart represents, in a sense, all that we go right and all that we got wrong about the markets over the past six or seven years. Going back to 2002 and 2003 we argued incessantly that we liked all things ‘commodity’ because relative prices within the various markets were severely out of balance. From early 1995 through into 2001 the stronger dollar trend had gone with years of relative strength by the financial sector compared to real assets or commodity prices. In other words the pendulum had swung so far that there was almost no where for it to go but back in the opposite direction.

If there was a turning point to mark the end of the old trend and the start of the new it might well have been the September, 2001 terrorist attacks because from that point in time forward money began to move away from the dollar and U.S. large cap equities towards the smaller, foreign, and commodity price-sensitive markets.

We forecast the recovery of real asset prices but we underestimated the extent both in terms of time and price of the adjustment. In other words we called the turn but neglected to stick with the new trend for anywhere near long enough.

The PD/JPM returned to the 1995 starting point in early 2007 following FCX’s take over bid for PD and for all intents and purposes this could well have marked the end of the adjustment. Instead commodity-based momentum continued to build as the dollar broke through support around the 80 level leading to what we still view as a trend ‘over shoot’ that extended through until last week. In terms of ‘time’ the markets favored the dollar for roughly 6 1/2 years from the spring of 1995 through the autumn of 2001 and then favored everything else BUT the dollar for the next 6 1/2 years into the spring of 2008. Our sense is that if the U.S. Dollar Index successfully moves back above the 80 level then it will mark the start of a new trend that will, over time, favor the dollar, financial assets, and most especially U.S. large cap equities.


Equity/Bond Markets

Below we show the Nasdaq Composite Index and the stock price of the Bank of Montreal (BMO) from 2000. Below right we show crude oil futures and the stock price of Fannie Mae (FNM) into 2008.

We are comparing the trend that pushed the Nasdaq higher into 2000 with the commodity-based trend that elevated crude oil prices through 110 this year.

We are comparing the stock price of Canada’s BMO into 2000 with Fannie Mae into 2008. The argument is that money was moving towards the dollar into 2000 and away from the commodity currencies so the offset to strength in the Nasdaq was weakness in the Cdn banks. In the current cycle money has been moving away from the dollar so the offset to strength in commodity prices has been weakness in U.S. and Japanese financials. To the extent that the chart of FNM into March of 2008 is almost identical to that of BMO into 2000 we find the comparison somewhat intriguing.

Our point is somewhat short-term in nature. In March of 2000 the ‘turn’ began once BMO snapped higher on the first break in the Nasdaq which, we will argue, was very similar to what FNM did last week on oil price weakness. The twist is that the Nasdaq- after breaking down to the 50-day e.m.a. line- made one last rally attempt back to the highs before crumbling back through the 200-day e.m.a. line in April.

As the Nasdaq pushed back to the highs in late March of 2000 the rally in BMO was halted for a mere three trading sessions before prices pushed on to new recovery highs and then resolved back up through the 200-day e.m.a. line.

The change in trend in 2000 was marked by the first peak in the Nasdaq and the concurrent low for BMO followed by a reversal by both markets. After correcting back to just above the 50-day e.m.a. line the Nasdaq returned to the 5000 level but- most telling- the recovery in BMO continued.

In the present situation we can see that crude oil futures prices corrected rather sharply last week falling from roughly 110 through 100 before closing just under 102. In response we can also see that Fannie Mae shot to the upside which suggests that for the first time in many months we could be witnessing the very start of a significant trend change.

Our example suggests that it is possible that even if this is the change of trend that we have been looking for that crude oil prices could spend the next week or two working back towards the recent highs. In a perfect world this would halt the recovery in the financials for a few days but even as the oil ‘bulls’ clamber back on board in anticipation of a return to the rising price trend the recovery in the stock price of FNM would gain sufficient traction to move it back above the 200-day e.m.a. line in the mid to high 40’s which would then lead to a collapse in crude oil prices during the second quarter of the year back towards the low 80’s. At this juncture none-energy cyclicals like the airlines would return to life to help push the S&P 500 Index to the upside.

Obviously the markets may resolve in an entirely different manner but we do find our thesis somewhat appealing given the close proximity to the end of the quarter. The better the financials do the greater the downward pressure on commodity prices.