by Kevin Klombies, Senior Analyst TraderPlanet.com
Wednesday, July 9, 2008
Chart Presentation: Ratio Adjustment
July 8 (Bloomberg) — Crude oil fell more than $5 a barrel, the biggest decline in three months, as signs that the global economy may slow prompted investors to sell commodities.
July 8 (Bloomberg) — Soybeans fell for a second straight day on speculation record energy prices have slowed the global economy, prompting investors to sell commodities.
July 8 (Bloomberg) — Copper dropped to the lowest in three weeks on speculation thecredit crisis will continue to slow global economic growth, curbing demand for raw materials.
July 8 (Bloomberg) — Canada’s dollar declined the most in almost a week as the price of the nation’s commodity exports, including gold and oil, fell.
July 8 (Bloomberg) — Brazil’s real fell for the first time in three days on concern a slowing global economy will curb demand for Latin America’s commodity exports.
The first chart shows the ratio between equities (S&P 500 Index) and long-term Treasuries (30-year T-Bond futures) from October of 1986 through into early 1988.
The argument is that the stock market’s ‘crash’ in October of 1987 at the start of a new quarter was less a harbinger of economic doom than an adjustment of relative prices. For 3 straight quarters the value of equities had risen relative tobond pricesas the SPX/TBond ratio climbed from around 3:1 up to just over 4.9:1. In a very short period of time the ratio snapped right back to its starting point as declining equities eventually led to centralbank interest ratecuts and rising long-term bond prices.
Our view is that the relationship that is severely ‘out of whack’ is the ratio between commodities (CRB Index) and equities (S&P 500 Index). The ratio pushed upwards for 3 straight quarters starting in October of last year and has recently turned lower now that a new quarter has begun.
The 1987 example is definitely quite extreme in that the adjustment to the ratio took place in a very short period of time. The thesis is that the CRB/SPX ratio will return to last summer’s levels around .22:1 but we are unsure of whether this will be accomplished this month or drag out through the balance of the year.
In the second chart below we have included a chart of Cisco (CSCO) from 2006.
The point that we would like to make is that earnings season began yesterday with the release of Alcoa’s numbers. Between now and mid-August most major U.S. companies will report but it isn’t the numbers that are important but rather the markets’ reaction to those numbers. In August of 2006 Cisco surprised the market and the stock ‘gapped’ to the upside. This is the sort of action that we are looking for to help us sort out what the trend will be over the balance of the year. In other words we aren’t arguing in favor of CSCO but are instead suggesting that one should pay attention to powerful stock price ‘gaps’ to the upside in sectors that have previously viewed as negative by the markets.
Below right we show Schering Plough (SGP), Sprint (S), and the ratio between the S&P 500 Index and the DJ AIGCommodity Index.
The basic point is that stocks such as SGP and S were an integral part of the trend that favored commodities over equities into the end of the first quarter this year. Since then both stocks have recovered nicely so a case can be made that the equity/commodity ratio could snap rather briskly back to the upside as equities outperform raw materials prices.
Below we showcrude oil futuresand the ratio between ExxonMobil (XOM) and Boston Scientific (BSX). We use the XOM/BSX ratio to measure the direction of the energy versus health care trend.
The lows for crude oil prices have tended to go with corrections in the XOM/BSX ratio back to or below 6.5:1. It is difficult to argue that anything has actually changed even after the two-day slide in crude oil prices. We would like to see this ratio take out the April lows to indicate that the trend has turned in favor of health care and away from energy.