by Kevin Klombies, Senior Analyst

Thursday, July 3, 2008

Chart Presentation: Oil Lags

July 2 (Bloomberg) — The euro may be nearing an “explosive breakout,” reaching record levels against the U.S. dollar, according to a Citigroup Global Markets Inc. research note.

The point that we have been trying to make over the last few days is that the euro has reached a decision point of some importance and that an ‘explosive breakout’ would tend to support the rising commodity theme with particular emphasis on gold prices. The consensus view is that the ECB will raise interest rates by 25 basis points today to 4.25% but regardless of what the decision may be it is the markets’ reaction that is of importance. Rising European interest rates and new highs for the euro may serve as commodity markets positives but they are also very negative for the equity markets.

At right we show the Nikkei 225 Index and crudeoil futuresfrom 1989 through 1990.

The Japanesestock marketreached a bubble-like peak at the start of 1990 while crude oil prices did not reach a high until roughly nine months. later. Today’s argument is that on two separate occasions since 1990 a financial markets price peak was followed roughly three quarters later by a top in energy prices.

Below right is a chart of the Nasdaq Composite Index and crude oil futures prices from the summer of 1999 through into early 2001. The chart covers the cycle peak for the Nasdaq reached in March of 2000.

The Nikkei reached a high in January of 1990 followed in October by a top for crude oil prices. The Nasdaq, on the other hand, topped out in March of 2000 with crude oil prices turning lower around the end of November. On occasion we show the energy trend through 2000 using the product ofcrude oiltimes natural gas prices because as crude oil weakened in December of that year natural gas prices spiked to a high. The combination of oil times natural gas pushed to a high very close to nine months after the final peak for the Nasdaq.

Our point is that for as unique and relentless as the current cycle may feel in many ways it is not much different than both 1990 and 2000 when the final top for energy prices followed the start of weakness in an equity market that had previously served as the focal point for capital flows. We will continue with this argument below.



Equity/Bond Markets

At right we show the Shanghai Composite Index and crude oil futures from the current time frame. China’s equity markets rose to a major price peak into October of last year so if history were to repeat almost exactly the final high for crude oil prices should be reached nine months later which, of course, lines up with July of 2008.

Below right we show a stacked comparison of the S&P 500 Index (SPX), the Amex Oil Index (XOI), the ratio between the share prices of Caterpillar (CAT) and Pepsi (PEP), and thestock priceof CAT.

The argument has been that in both 2006 and 2007 the S&P 500 Index worked through a fairly intense correction that did not end until CAT, the CAT/PEP ratio, and the XOI declined to or below their respective 200-day e.m.a. lines. This time could always be different but our view was that we would have considerably greater confidence in a sustainable stock market recovery once these three markets had moved to or below their moving average lines.

CAT has clearly broken below its moving average line and as of yesterday the CAT/PEP ratio had declined to levels associated with stock market bottoms in both 2006 and 2007. The Amex Oil Index remains about 50 points above support.

In both 2006 and 2007 the trend shifted from cyclical to consumer at the half way point of the year. In other words the CAT/PEP ratio peaked and then began to trend lower.

The problem is that this trend change led to two very different outcomes. Below we show that the CRB Index peaked into July of 2006 and then declined through into January of 2007 while in 2007 the major banks (we show Citigroup (C) for our comparison) turned to the down side in July. We can get better financials, pharma, and consumers if commodity prices decline and better commodities if the banks shift into yet another period of crisis. In both 2006 and 2007 the trend that would dominate for the next six to seven months was not exactly obvious at the very beginning of the month of July.