by Kevin Klombies, Senior Analyst

Thursday, November 8, 2007

Chart Presentation: Overview

At right we show a comparative view of the sum of 3-month and 10-year Treasury yields, the ratio between equity (S&P 500 Index) and commodity (DJ AIG Commodity Index) prices and the CRB Index.

The equity/commodity ratio has fallen sharply but remains well above the lows set in the middle of 2006. The reason for this is that interest rates in general have declined.

The equity/commodity ratio turned higher in the summer of 2006 just ahead of the decline in oil prices. We have argued in the past that there is risk in the equity markets between the peak for copper prices and the ensuing start of weakness in crude oil prices. With the trend for copper turning lower in July and oil prices making new all-time highs yesterday clearly we are still stuck within this particular pocket of ‘risk’.

Lower interest rates would help to support the equity markets. 10-year U.S. Treasury yields have been stuck just above 4.30% since early September. The chart below suggests that once yields break below 4.30% the next stop should be somewhere close to 4.0%.

Ideally oil prices tip over and the CRB Index starts to decline as 10-year yields break below 4.30%. This would take considerable pressure off of the financials and allow the large cap consumer and pharma sectors to strengthen as an offset to cyclical sector weakness.



Equity/Bond Markets

When the markets get overly volatile we tend to focus more on long-term or macro themes. It seems to help us find some form of perspective.

Years ago we argued daily in favor of the commodity sector. The gist of the argument was that the markets had left the commodity cyclicals behind following the huge stock market ‘ramp up’ between 1995 and 2000.

At right we show a comparison between the stock price of Phelps Dodge (PD)- which was bought out this past spring- and the SPX, the ratio between the Morgan Stanley Consumer and Cyclical indices, and the ratio between General Electric (GE) and the SPX).

For as complex as the markets appear to be most days this is about as basic an explanation as we are able to present. Between 1995 and 2001 the markets loved consumer stocks and names like GE and hated commodity cyclicals like PD. The rally in commodity prices and decline in the dollar pulled the consumer/cyclical ratio and the GE/SPX ratio back to ‘support’ and drove metals producers like PD back to long-term resistance.

Our basic argument is that the correction in relative prices that had to happen after 2000 is now complete and it is time for the markets to move on to something new. Our conviction is that this will go with a return to strength for the large cap consumer and pharma names, a better dollar, and a multi-year period of consolidation for the commodity sectors.

Below are two charts of Merck (MRK) and Wal Mart (WMT). The chart below right is from 1993 into 2000 while the chart below starts at the end of 2003.

The ongoing argument is that while WMT trends with the large cap consumer/pharma theme it tends to lag at the start. Between 1994 and the end of 1996 WMT’s stock price moved sideways only to pivot higher at the peak for crude oil prices. Since oil prices reached record levels yesterday it makes intuitive sense that WMT is still slogging essentially sideways. It should break above 51, however, after oil prices finally turn lower.