by Kevin Klombies, Senior Analyst TraderPlanet.com
Wednesday, November 28, 2007
Chart Presentation: Markets Drama
Crude oil prices declined more than 3 points yesterday and the U.S. equity markets responded positively. The only problem was that yesterday was a ‘Tuesday’ and for months we have been pointing out that Tuesday price weakness has typically been followed by late-week strength. Even if crude oil prices strengthen later this week it made for a nice change of pace.
At right is a chart comparison that we have been showing off and on for several months. The chart shows crude oil futures, the ratio between Caterpillar (CAT) and Pepsi (PEP), and the stock price of Caterpillar.
The argument is that when CAT turns lower it marks the start of a declining trend for the commodity cyclical theme. Usually CAT’s stock price begins to decline it means that metals prices have peaked. In the recent past the commodity markets have tended to make two tops- the first concurrent with the peak in copper prices and the second a few months later with the top in crude oil prices.
The CAT/PEP ratio is one way to follow the direction of money within the equity markets. When the ratio is rising capital is flowing towards the commodity theme which generally goes with rising interest rates and when it is falling money is moving away from cyclical and back towards the more defensive consumer staples names.
The chart detail that we have been focusing on can be seen into the summer of 2006. After CAT and the CAT/PEP ratio began to trend lower there was a period of roughly three months when oil prices continued to push upwards. The underlying trend, however, was negative so once oil prices finally turned back to the down side the decline continued until crude oil futures had returned to the downward sloping trend line. This line was hit in October of 2006 and then again in January of 2007.
The challenge this year is that CAT and the CAT/PEP ratio peaked in July and are still trending lower. We were looking for a second top for commodity prices in October concurrent with the recovery rally peak for CAT but just to mix things up oil prices ratcheted upwards from around 80 to just below 100. As we come to the end of November we note that the trend line that crude oil prices were supposed to follow is now so far below current prices that it will take something… dramatic… to bring crude back ‘on trend’.
Recently the Alberta government increased royalties on the oil and gas sector and yesterday Canadian Natural Resources (CNQ) announced a 27% reduction in its capital spending budget for 2008. The Canadian dollar declined about 1 cent against the U.S. dollar and the stock price of CNQ fell back to levels last seen when crude oil prices were closer to 65.
The chart at right compares the Cdn dollar (CAD) futures with the ratio between the Cdn and Japanese i-shares (EWC/EWJ). We have been showing this view almost daily for the past few weeks. The argument is that the trend that was pushing the Cdn dollar higher was also ramping the Cdn equity markets up against the Japanese equity markets. In a commodity-based theme a country that produces commodities (Canada) does much better than a country that uses commodities (Japan).
The point is that if we hold a negative view on the Cdn dollar then we have to expect the Japanese equity market to outperform. It is not always easy being positive on the Nikkei because it has consistently led to the down side on corrections but, we suppose, that is to be expected as long as the equity markets are locked on to the commodity theme. What we have been looking for is a change in that theme that will be marked by rising instead of falling equity prices on U.S. dollar strength. Since that is what happened yesterday we were definitely encouraged.
Below are two charts of Wal Mart (WMT) and Merck (MRK). We do not know if WMT qualifies as the ‘hard trade’- the trade that is so universally assumed to be wrong that it has to be right- but from an intermarket perspective it still looks as if this is definitely a question of ‘when’.
The chart below shows that MRK began to rise several years before WMT during the 1990’s. WMT did not kick upwards until crude oil prices finally peaked at the start of 1997. With MRK trending steadily upwards since late 2005 our oft-repeated point is that one of the ways we will know that oil prices have finally topped for the cycle will be through the reaction in WMT. Above 52 would definitely make things interesting.