Most days we start off with an initial idea and then proceed to lay out a variety of charts to create a theme. As the trading day progresses we invariably discover that there are other charts that we want to either introduce or update so we cram them into whatever space we can find. By the time we actually start writing the original theme or thesis may have been totally obliterated. The next day we start all over again.
It always amazes us that no matter how many perspectives and arguments we have shown over the years there is always the sense that we simply do not have the time or space necessary to explain our thoughts on the markets. Of course if we didn’t burn part of a page rambling on about how we don’t have enough time or space… that might not be a problem.
In any event… today’s theme starts with the idea that the cyclical trend appears to have shifted in terms of time. Through the end of the previous decade cyclical strength tended to show up from January through June while in recent years the trend appears to have been focused into the October through March time frame.
First is a chart comparison between gasoline (RBOB) futures and oil refiner Valero (VLO) from late 2006 into 2007.
We have to be careful here because ‘cyclical trend’ is not exactly what we mean. Through the previous decade the cyclical trend was defined by energy and base metals prices and year after year these sectors tended to rise quite strongly through the first six months of the calendar year. In 2007 this created a bullish trend for gasoline futures prices and a significant rally for Valero from January into July followed by a pivot into a bearish trend.
Next is a chart of 10-year Treasury yields. Notice that in 2006, 2007, and 2008 the trend for yields was higher from January through June and then lower from July into year end.
The point? In past years the markets were dominated by two trends. Over the first six months energy and base metals price gains pushed yields higher. Over the final six months yields moved lower while the markets focused strength on other sectors. What intrigued us back then was the way ‘other sectors’ would change from year to year. This would include defensive stocks one year, energy ‘users’ like the autos and airlines another year, and even gold prices and the gold miners.
So… the initial argument was that the energy and base metals trend used to run from January through June. Now it looks a bit more like it is being squeezed into the October through March time frame.
First below is a chart of gasoline futures and Valero from 2011- 12. Notice that Valero made a peak in March of 2011, a bottom at the end of September, and then a potential peak last month. To the extent that Valero trends with gasoline futures prices the argument would be that trend for energy prices should now be negative through this year’s third quarter.
Once again… what is the point? The point is that if the energy and base metals price trend has essentially shifted forward by a quarter then we should be in the early stages of the ‘other sectors’ trend.
The challenge lies in trying to discern how the markets will respond to weakness in energy prices.
In recent issues we suggested that perhaps this will be the quarter when Johnson and Johnson (JNJ) surprises the markets with stronger than expected earnings. Alas… such was not the case. We weren’t pulling this particular argument out of… thin air… as we were actually trying to figure out what ‘other sectors’ might entail.
To explain we have included a chart of 10-year Treasury yields and the ratio between Johnson and Johnson (JNJ) and the S&P 500 Index (SPX) below
If weaker energy prices lead to falling yields then the JNJ/SPX ratio should rise. Yet it is not actually a certainty that weakness in energy prices will lead to falling yields. That is normally the case but one could imagine a scenario in the current environment where declining gasoline prices are perceived as economically positive. So while we believed that the trend for energy prices should be lower we were less certain about how the bond market’s reaction. Hence… our focus on JNJ.
Another possibility in terms of ‘other sectors’ would be the autos and airlines. We will expand on this, but the argument is that weakness in the Brent crude/CRB Index ratio could lead to a bullish response for the autos (i.e. a rising Ford/SPX ratio).
