by Kevin Klombies, Senior Analyst

Thursday, March 20, 2008

Chart Presentation: Offsets

Aside from the fact that the equity markets declined yesterday under the weight of falling commodity prices we found the session rather refreshing. Enjoyable even because to start a new trend the old one has to come to an end and that is most certainly how things feel at present.

Below we show a stacked comparison of four different themes. At bottom is a chart of Intel (INTC), followed by Boston Scientific (BSX), Rider Resources (recently taken over), and gold futures. Rider was a Canadian natural gas producer so we are using it to represent the gas portion of the energy theme.

From 1999 into 2000 the dominant theme was ‘tech and telecom’ so as INTC pushed higher the stock price of BSX declined. When the Nasdaq finally turned lower in 2000 it ushered in a new trend that helped lift many of the financials, home builders, pipelines, utilities, as well as BSX.

BSX rose in price from late 2000 into the spring of 2004 and then as it rolled over the markets turned to commodity theme. Rider (RRZ) began to move upwards in price until a peak was reached at the end of 2005. From there the markets shifted gears into a new trend that included commodity prices in general and gold prices in particular.

Each rising trend is an offset of a declining trend. Intel rose as BSX declined, BSX rose as Intel declined, natural gas prices surged as the consumer stocks weakened, and eventually gold prices shot skyward as the financials and biotechs trended lower.

The point is that the greater the pain in one sector the greater the lift in another so gold getting through 1000 was a reflection of the excesses created by the major banks and brokers earlier in the cycle combined with the extended period of consolidation for stocks such as INTC. Our appreciation of the weakness in commodity prices has less to do with- we hope- a curmudgeonly response to a trend that has left us behind and more to do- we hope- with the expectation that declining commodity prices will mark the start of a lift in some new sector or asset class.

The challenge will be to identify the next positive offset and then, if it appears in an unexpected place, NOT argue with it for the next couple of years. Life is much more enjoyable when one is trading with a trend instead of arguing against it.


Equity/Bond Markets

Below we show a comparison between, from bottom top, the ratio between the share prices of Johnson and Johnson (JNJ) and FreePort McMoRan (FCX), the share price of Wal Mart (WMT), and the sum or combination of the Canadian (CAD) and Australian (AUD) dollar futures.

The CAD plus AUD defines or goes with the commodity trend. When these currencies are strong and rising the commodity trend is positive. When the commodity trend is positive stocks like FCX will outperform stable growth names like JNJ. Hence when the sum of the CAD and AUD is rising the JNJ/FCX will be falling. Fair enough.

The last major commodity trend came to an end back in 1996. Bre-X’s monster gold find in Indonesia turned out to be a hoax and the shortage of physical copper pushing prices into backwardation (spot higher than deferred futures) was the result of a trader’s market manipulation that eventually cost his employer a few billion dollars. As this trend turned negative the JNJ/FCX ratio and WMT turned higher as the commodity currencies turned lower. Our argument is that the current situation is in some ways similar to 1996.

Of course the major difference between now and late 1996 would be that nothing has actually broken up or down as of yet. To explain we show Rio Tinto (RTP) and the sum of the CAD and AUD below right.

If we are at the trend change then it is still very early. At minimum RTP and the CAD plus AUD are going to have to do more than decline to the 200-day e.m.a. lines and then rally upwards once again. One or, more likely, both are going to have to break a moving average line suggesting that RTP and around 350 and the CAD plus AUD sum at 1.85 will be key decision points.

Quickly… there have been three periods of markets-related crisis in the past decade or so- the Asian crisis in 1998, the Nasdaq collapse in 2000, and the recent subprime fiasco. The chart below shows that each time Japanese short-term interest rates have moved upwards (euroyen futures prices declining) one or more markets implode. Ideally the Bank of Japan would hammer short-term yields back to 0% so that we could get on with the process of creating the next bubble and inevitable crisis.