Chart Presentation: Perspective

After reviewing the markets through the end of last week we have come to a conclusion of sorts. Either the markets are on the edge of a complete collapse or we end last week at levels that can easily support a very strong recovery. Either this is the last chance to be a seller or the best time to be a buyer. We can make a reasonable case for both outcomes but at present we favor the latter of the two. In other words in the face of seemingly incontrovertible evidence we remain rather bullish on the equity markets. Nervous but bullish.

The more frantic the short-term trend the more likely we are to start off the IMRA with a long-term perspective and that is most certainly true today. At top right we feature the ratio between the stock price of former copper producer Phelps Dodge (PD) and the S&P 500 Index along with 3-month eurodollar futures.

The markets pushed the equities of the commodity producers to a peak in 1981 and again 13 years later in 1994. In both instances this peak went with a bottom for eurodollar prices which simply means that when the commodity sector is at a high we would expect a concurrent peak in U.S. short-term interest rates.

Since Phelps Dodge was taken over last year by FreePort McMoran (FCX) we are forced to use the FCX/SPX as a surrogate for the PD/SPX ratio. We do so below right.

The point is that for the third time in close to three decades the markets have worked through what appears to be roughly a 13-year cycle culminating with a relative strength peak in the commodity or base metals sectors. The PD/SPX ratio topped out in 1981 and then again in 1994 followed 13 years later by the late-2007 highs. In each case this has gone with the highs for U.S. short-term interest rates.

Our initial point today would be that while the current cycle would appear to be a singular and wholly unique event without any historical precedent it really isn’t. The markets are, by and large, simply going through a state of crisis that typically goes with major changes in trend. After years of playing ‘catch up’ following the bull market in the financials, pharma, consumer, and tech sectors through the second half of the 1990’s the commodity sector has done what it needed to do. It has had its day in the sun and now it time for new leadership and, if history is any guide, it will take at least five years for the metals and miners to wash out before the next period of recovery begins.

At right we show the stock price of U.S. home builder DR Horton (DHI) and 3-month euroyen futures. Euroyen prices- similar to TBills- are based on a discount to 100 and reflect the trend for short-term Japanese interest rates.

Crises do not appear ‘out of the blue’. They tend to show up after conditions have deteriorated for an extended period of time. We will argue that the current state of crisis is a reflection of at least two trends- rising short-term Japanese interest rates and a steady flow of capital away from the dollar.

In early 2006 two things began to happen within the markets. First, short-term Japanese interest rates began to rise and this went with the start of a correction in the U.S. real estate market. Second, the dollar began to decline once again as capital moved away from the slowing U.S. economy towards those sectors offering higher potential returns.

Now consider the chart below right of Mitsubishi UFJ (MTU) and Bear Stearns (BSC). Notice that the ‘base’ trend turned negative in early 2006 following the start of rising Japanese short-term yields. In the spring of 2006 MTU was trading at 16 with BSC trading just above 145. By late 2007 into early 2008 we find that MTU had fallen by roughly 50% to 8 while BSC is now in the low 70’s. In other words while the decline in the U.S. financials may have been somewhat more dramatic both stocks turned negative in early 2006 and both declined by close to 50%.

Our point is that the negative trend for the financials went with falling euroyen prices AND a falling U.S. dollar. At the point in time (i.e. now) when there is an apparent risk of a complete collapse we find that the euroyen futures AND the dollar have stopped making new lows and while the U.S. financials have most definitely been weaker into early 2008 we also find that MTU has been trading almost flat since last September. In other words it is possible that the markets are set to go from bad to worse but it is not a given.