Chart Presentation: Relative Prices

There are no good days or bad days in the markets; merely days when your thesis is right or wrong with the trend. From our perspective yesterday was a very good day, however, simply because we have been dollar positive, commodities negative, and have favored U.S. large caps in the consumer non-cyclical and health care sectors.

The CRB Index (properly called the Reuters/Jefferies CRB Index) suffered its worst one-day decline since March (which, we should add, is not that impressive given that March was not that long ago) and some real blood was shed in the share prices of some of the commodity cyclicals. Potash Corp. fell 20.92, FreePort McMoran was down 10.96, while Schlumberger was down 5.79. We read comments from those positive on the commodities sector suggesting that it was likely time to start scooping up the bargains. Perhaps but… perhaps not.

Below we show the ratio between the S&P 500 Index and the U.S. 30-year T-Bond futures from 1986 through into early 1988. The focus of our attention is on the huge run up in equities versus bonds through the first nine months of 1987 followed by the rather abrupt collapse of the ratio back to its original starting point. Keep in mind that the equity markets ‘crash’ in 1987 did not mark the end of rising stock prices but it did serve to bring relative prices back into line while soundly spanking those momentum traders who had come to believe that the markets traded in straight lines instead of cycles.

We have argued on occasion that the ratio between commodities and equitiesfrom the autumn of 2007 through the first half of 2008 appears very similar to equities versus bonds in 1987. Our point was that the ratio between the CRB Index and the S&P 500 Index had ‘ballooned’ to the upside over a nine month time span and could, if history were to broadly repeat, snap all the way back to the levels last seen last summer. In other words the CRB/SPX ratio could snap down towards .22:1.

When we have put numbers to a ratio of .22:1 we have suggested that the CRB Index could decline to 310 while the SPX moves back up to 1400. In other words… we remain somewhat stubbornly positive on the equities of commodity users while remaining negative on those companies that are strictly commodity producers.

Our point? While the CRB Index has declined from around 472 to 402 since the start of the quarter we can not even imagine shifting to a positive view in the foreseeable future until the index fell another 90 or so points down to the vicinity of 310.

The second chart below shows the ratio between the S&P 500 Index (SPX) and crude oil futures.

The chart makes the rather simple point that the U.S. equity market has been weak relative to crude oil prices since January of 2007. Over the intervening 18- 19 months there were numerous (i.e. many) occasions when crude oil prices would start to ramp higher at the exact same time that equity prices moved lower. It felt very much as if the favored trade was to buy crude oil and sell the SPX as a ‘pair trade’.

Our point is that if this trade reverses then at minimum the ratio HAS to move well above 10:1. In fact we would expect it to blow through 11:1 in a hurry and move up towards 13:1- 14:1 with ease. Chart-wise this makes sense to us but it gets a bit more interesting when you put numbers to the ratios. Given our view that the SPX could snap back up to 1400 we are obviously arguing for crude oil futuresprices at or below 100.

The page 1 argument was that the CRB/SPX ratio in 2008 appears similar to the SPX/TBonds ratio in 1987. In 1987 the equity markets collapsed while bond prices rose but… the key is WHEN bond prices started to move higher.

The chart at bottom right compares the 1987 SPX with the U.S. 30-year T-Bond futures. Notice two things. First, it didn’t take very long (i.e. two days) for the SPX to reach bottom once the 200-day e.m.a. line was broken. Second, the bond market didn’t begin to rise until the SPX had hit bottom.

The CRB Index declined to the 200-day e.m.a. line yesterday so it is now at what should serve as key support. Our thought is that if the commodity price decline were to accelerate then the closer the index gets to 310 the greater the upward pressure on the SPX.