by Kevin Klombies, Senior Analyst

Wednesday, May 7, 2008

Chart Presentation: Nikkei/Copper

Perhaps the most dominant trend since last summer has been weakness in the financials along with concurrent strength in the energy sector. With the financials showing strength yesterday in the face of yet another record high for crude oil prices perhaps we can be forgiven for lapsing back into a macro perspective to start things off today.

The chart below compares the U.S. Dollar Index (DXY) futures and the ratio between Japan’s Nikkei 225 Index and copper futures.

The first point that we wish to make is that time and time again through the decade of the 1990’s the Nikkei/copper ratio pushed up to or above the 250:1 level.

The second point would be that bottoms for this ratio tend to go with bottoms for the U.S. dollar. When the dollar turned upwards in both 1992 and 1995 the Nikkei/copper ratio began to recover until it eventually moved back above 250:1.

The chart below right features the same comparison over a much shorter time frame. Notice that the ratio made a low this past March at the initial bottom for the U.S. Dollar Index.

One of our arguments over the years has been that markets take turns and that over time relative prices will tend to adjust. Back in 2002 and 2003 we argued that through the 1995- 2000 equity bull market the commodity sector had been left behind so it was time for commodity prices and the stocks of those companies that produce commodities to play ‘catch up’. Five or six years later we are still trying to figure out when this process will be finally be completed.

In any event… the idea that we are attempting to communicate today is that while commodity prices were most certainly left behind following the consumer and tech-led bull markets of the previous decade a similar case can be made for Japanese asset prices today. The charts show that the Nikkei is currently trading at roughly 1/7th the levels relative to copper that have marked past peaks and that the start of a period of relative price adjustment will begin as the dollar strengthens. The issue today, of course, is whether the dollar has finally reached its cycle lows.



Equity/Bond Markets

Below is a chart comparison between the S&P 500 Index (SPX) and the ratio between the stock price of Canadian Natural Resources (CNQ) and crude oil futures.

CNQ is a major Canadian oil and gas producer with exposure to the Alberta oil sands.

The idea is that, as one might expect, in a rising equity markets trend the stock price of CNQ will outperform crude oil futures prices. At or close to the recent peaks for the SPX the CNQ/crude oil ratio has risen to more than 1.1:1 which simply means that stocks in general tend to get a bit toppy when CNQ’s share prices rises to around 10% higher than oil prices.

The ratio can rise, of course, if oil prices decline, CNQ’s share price rises, or some combination of the two. The problem from our perspective is that while the equity markets have turned positive the focus has primarily been on the energy sector.

CNQ ended very close to 92 yesterday so what happens next depends in large part on whether crude oil over 120 is ‘real’. If it is then CNQ could quite easily be heading back to something between 120 and 135.

Our struggle with this has everything to do with our views on the dollar and, by extension, crude oil prices. Our conviction is that the trend went from relentless to something close to obscene after the U.S. Dollar Index failed below the 80 level last September at the start of the subprime mortgage crisis. If we view anything below 80 for the dollar as extreme and know that as the dollar broke below 80 crude oil prices concurrently broke up above 80… then anything above 80 for crude oil is equally extreme.

If crude oil at 120 is ‘fair’ then the oil stocks still have considerable room to rise but if our view that crude oil prices above 80 are a function of a weak dollar that was caused in large part by weakness in the financial sector and we note that the financials seem to be recovering quite nicely at present… then oil stocks are current prices are definitely ‘rich’. Put another way at 80 crude oil the stock price of CNQ at 92 would be high but at 120 crude oil it remains a bargain.

The chart below right compares the stock price of Wells Fargo (WFC), the stock price of Carnival Cruise Lines (CCL), and the ratio between the Amex Oil Index (XOI) to the S&P 500 Index (SPX).

When oil prices are strong- as they are and have been- the oil stocks outperform the broad market. At major cycle peaks for crude oil prices, however, we tend to find stocks such as WFC and CCL well below their moving average lines so our focus of late has been on watching WFC rally up to or just above its moving average line only to slump lower as crude oil prices rise another 20 to 25 points.

Last Friday WFC and CCL had risen to levels that indicated the markets had reached a decision point. Over the past few months the markets have consistently chosen ‘higher oil prices’ as the preferred outcome with the rally to the next peak for crude lasting close to month. The problem is that even after crude oil prices have gained roughly 10 points in three trading sessions to hit new highs… we find WFC still trading above 31. To us this suggests that this is not the start of a new rally for oil prices but rather the last few days of the previous rally. We may well be splitting hairs here but we still view this as an important distinction.