by Kevin Klombies, Senior Analyst

Tuesday, February 26, 2008

Chart Presentation: Redux

In yesterday’s issue we introduced the argument that the equity markets are lagging behind the commodities sector by close to one year. The idea was that the CRB Index turned higher during the fourth quarter of 2001 while the S&P 500 Index remained negative until the final quarter of 2002.

During the second half of 2006 the CRB Index broke lower until it had fallen well ‘below trend’ while the equity markets continued to rise until the second half of 2007.

After bottoming in January of 2007 the CRB Index began to recover led in large part by strength in energy prices with considerable help during the second half of the year from the grains. By the first quarter of 2008 the chart at top right shows that the CRB Index had swung back above the rising support line arguing that the trend for asset prices had returned to positive.

The chart below shows the CRB Index from 2005 forward while the chart at bottom right shows the S&P 500 Index starting in 2006. To account for the lagged response by the equity markets we have shifted or offset the charts by one year.

Commodities are ‘assets’ much in the way that real estate is an asset. We are actually not suggesting that U.S. house prices are going to return to new highs by next year but are instead arguing that in the attempt to slow the decline or even lift it somewhat the Fed is going to have to push significant amounts of liquidity into the markets. The liquidity intended to shore up the housing sector will undoubtedly move into whatever sector is showing the greatest momentum. In a sense as long as the housing sector remains weak the Fed will have to keep its monetary foot on the gas pedal which will in turn help inflate at an accelerated pace those sectors that remain relatively healthy.

In terms of the equity markets the argument would then be- if we take the comparison literally- that the SPX would return to the 1550 level around the end of 2008 on the way to an impressive break out and subsequent push towards 1650- 1700 by early 2009. In the interim, of course, we will have had a chance to see what the balance of 2008 has in store for the CRB Index.



Equity/Bond Markets

Below we show the U.S. Dollar Index (DXY) futures and the ratio between Phelps Dodge (PD) and JP MorganChase (JPM) from late 1993 into the spring of 2007. PD was bought out by FreePort McMoRan (FCX) last year.

The basic argument back in 2002 and 2003 was that the commodity sector should swing higher to adjust relative prices and in the process it would push the dollar lower. In other words the trend from 1995 into 2001 pushed bank stocks like JPM higher relative to mining stocks like PD and in the process this went with a very strong dollar.

To correct the excess the markets had to swing back to a commodity-driven theme elevating the miners relative to the financials while pulling the dollar lower. The chart shows that the PD/JPM ratio had returned to its late 1994 starting point in the spring of 2007 with the U.S. Dollar Index close to the 80 level.

The markets- as always- are full of surprises and we were certainly caught unprepared by the break below 80 by the DXY last year. With PD no longer available to use as a trend surrogate were then forced to switch to FCX.

Our view is that the DXY below 80 represents an extreme of sorts. Our view was that the DXY would return to the 80 level- which, in fact, it did at the start of 2005- while the equity markets pushed the miners higher relative to the banks. Then we expected the trend to swing back in favor of the consumer and financial sectors as commodity prices declined and the dollar firmed. Instead we were told that it is different this time and that the demand for raw materials from China and India would remain unsated for years to come which certainly appeared logical after the dollar broke from 80 down to 75.

In response we suggested that our thesis could still make sense if the miners reached relative strength peaks during 2007 so we began to show ratios based on FreePort McMoran and the SPX along with JPM. We show the charts below right. Now that the ratios are on the rise it is time for the dollar to firm while metals and energy prices work lower. The peaks for the FCX-based ratios in November of last year and early January of this year coincide with tops for the sum of copper and crude oil and bottoms for the dollar.