by Kevin Klombies, Senior Analyst

Friday, November 2, 2007

Chart Presentation: Metal and Energy Prices

Our BIG argument for the last few years has been that at the peak for commodity prices we would reach a concurrent peak for interest rates and that this would result in a change of trend that would go with equity prices rising relative to commodity prices. To date- even after yesterday’s equity markets melt down- the argument remains stressed but intact.

At top right is a comparison between the sum of copper and crude oil (copper in cents and crude oil in dollars multiplied by three times) and the sum of the U.S. 30-year T-Bond futures and the U.S. Dollar Index (DXY) futures.

The idea here is that metals and energy prices are one side of the equation with the dollar and bonds on the other. We have recently been showing a comparison between the dollar in 2007 and the TBonds in 1987 to make the tentative point that the trends pre-crash are really quite similar.

The point is that in a strong commodity trend bonds and the dollar will trend lower. Intuitively this makes some sense since typically when commodity price are strong the markets worry about inflation which leads to lower bond prices. This time around the bond market has held steady as foreign central banks have ramped up the purchase of Treasury securities in an attempt to slow the rise in their currencies or, in the case of Hong Kong and China, defend a currency peg. The end result, strangely enough, is that the dollar has absorbed all of the pressure which, in turn, has served to support the bond market.

If one views the dollar and bond market as a combination then the downward pressure on the financial stocks makes a bit more sense. Even if bond prices aren’t falling the trend for bonds and the dollar is negative and will remain that way until the commodity trend stops pushing.

At bottom right we show the ratio between heating oil futures (energy prices) and the U.S. Dollar Index along with the share price of Bear Stearns (BSC). As energy prices have risen and the dollar has declined the markets have applied unrelenting pressure to the banks and brokers. As crude oil broached 96 yesterday morning the equity markets buckled sending the share prices of the banks and brokers lower. If this is going to be a bottom for the financials then this has to be a top for energy and metals prices.



Equity/Bond Markets

The chart at right compares the equity/commodity ratio (S&P 500 Index divided by the DJ AIG Commodity Index) with the stock price of Schering Plough (SGP).

We mentioned on page 1 that our strong equity/commodity thesis was stressed but still intact. The argument was that at the peak for energy and metals prices there would be downward pressure on interest rates which would then help support sectors like the financials, pharma, tech, and the consumers. The problem this year has been the huge recovery rally in the commodity markets. When equities are stronger than commodities AND commodity prices are rising then the markets focus primarily on the stock prices of the commodity producers, the currencies of those countries that produce commodities, and the main driver behind the rising trend for commodity prices (in this case that would most certainly be China and India).

Now… consider the page 1 chart of the sum of copper and crude oil. As of this week the sum had risen right back to the peak set in 2006. This is, as they say, good news and bad news.

If this is a second top for commodity prices then we can look forward to a recovery in the equity markets similar to the second half of 2006. If this isn’t the peak for commodity prices then… Houston, we have a problem. Which, we will argue, is what yesterday’s equity market decline was all about.

Circling back once again the beginning and end to this entire thesis rests with the position of the commodity markets. Is crude oil levitating up to 96 before snapping back- as we have argued- towards the low 60’s of was today a minor pause on the path of triple digits? With the ratio of oil to natural gas prices so high will gas prices rise or will oil prices fall? The same point is true for gasoline futures (page 3).

From our perspective we still like the bullish equity markets outcome which means that as usual we still like the bearish commodity markets outcome. At right is one explanation why we continue to hold this conviction.

We have argued in the past that there is roughly a 2-year lag between changes in the trend for interest rates and changes in the trend for commodity prices. We have argued that this explains very nicely why the CRB Index peaked in the spring of 2006 because two years previous the Fed had started to tighten credit conditions.

The problem, however, is that while short -term U.S. interest rates began to rise in the spring of 2004 European interest rates remained flat until the autumn of 2005. The chart at right shows that the first peak in the CRB Index in 2006 lines up with the end of low U.S. interest rates while the second peak (i.e. this quarter) lines up with the end of low European interest rates.

We suspect that the time difference between credit tightening in the U.S. and the Eurozone explains why it is that the U.S. real estate markets are weaker than, say, those of Spain. The Fed began tightening some 18 months before the ECB so in the months to come we expect the ECB will be pushing rates lower in an attempt to offset declining real estate prices in Europe.