by Kevin Klombies, Senior Analyst

Thursday, February 14, 2008

Chart Presentation: Not Up

Today’s general theme revolves around the idea that ‘not up’ is perhaps more important than ‘down’ with respect to major trend changes. To explain we have included two charts of the product of crude oil futures times the Australian dollar futures and the ratio between the share price of Wal Mart (WMT) and the S&P 500 Index (SPX).

The Australian dollar tends to trend with commodity prices. If memory serves roughly 40% of Australia’s GDP is directly related to the production of commodities compared to around 20% for Canada. We are combining the AUD with crude oil futures in order to smooth out the appearance of the basic ‘commodity trend’.

Wal Mart (WMT) tends to underperform the broad U.S. equity market during strong commodity price trends so we tend to view WMT as an anti or inverse commodity idea.

The WMT/SPX ratio bottomed at the start of 1997 concurrent with the cycle peak for the combination of crude oil prices and the Aussie dollar. The WMT/SPX ratio rose steadily from 1997 through 2002 as, good markets and bad, WMT outperformed the broad large cap market represented by the SPX.

By early 2003 the combination of crude oil times the AUD began to make new highs after trending flat to lower for six years. This marked the end of WMT’s relative strength and the start of a five year stretch of rather significant relative weakness.

In late 2007 the crude oil times AUD combination reached a peak and right on schedule (more or less) the WMT/SPX ratio began to rise. This brings us to the present day.

The intermarket argument is that the WMT/SPX should continue to resolve higher as long as the crude oil times AUD combination does not trade to new highs. It can drift higher or float sideways but in order for this to work it has to hold below the peak set during the final quarter of last year. In a sense ‘not up’ works just as well as ‘down’ for our purposes so as long as crude oil prices remain nicely below the 100 level our view will remain positive on WMT.



Equity/Bond Markets

The chart at right compares the pharma etf (PPH) with the combination of crude oil futures times RBOB gasoline futures.

From the peak in energy prices (oil times gasoline) in July of 2006 through 2007 the trend for the PPH was higher. This trend went with falling energy prices through the last half of 2006 and rising energy prices into the autumn of 2007 but when ‘not up’ turned to ‘up’ as the product of crude oil times gasoline broke to new highs the accompanying trend for the pharma sector turned back to negative.

Our basic argument has been that a recovery in the equity markets will require flat to lower energy prices. There are days when oil prices snug higher allowing the energy stocks to help lift the major equity indices but this will only work within the context of crude oil holding below the 100 level.

In yesterday’s issue we pointed out that the ratio of crude oil to gasoline is ‘high’ at present and because energy prices tend to trend in the same direction either oil prices have to fall or gasoline prices are going to rise.

The chart at right shows what happened in 2007 when the ratio reached similar levels. While one definition of insanity is repeating the same behavior and expecting a different outcome we still feel that this could resolve during 2008 through lower crude oil prices. If so… then similar to mid-2006 this should go with a bottom for the pharma sector.

Our point is that the crude oil times gasoline combination shown below right is either a pause on the way higher or a top reminiscent of mid-2006. Since we favor the latter choice we by necessity hold a positive view on the pharma sector.

Below we show copper futures and the ratio of Intel to the S&P 500 Index. The argument here is that copper prices do not have to be weak for INTC to perform as well as or better than the broad market but copper prices can not push on to new highs. As long as copper futures hold below the 4.00 level set in 2006 the INTC/SPX ratio should track sideways to higher. We remain positive on INTC, by the way.