by Kevin Klombies, Senior Analyst

Tuesday, August 12, 2008

Chart Presentation: Repeating Cycles

We start things off today with the comparative chart at right that includes the biotech etf (BBH), airline AMR, refiners Valero (VLO), gold miner Barrick (ABX), and natural gas producer Chesapeake (CHK).

We have argued in the past that the markets have been working through roughly 6-month trends. The first half of the year has focused on the broad energy theme while the second half of the year has featured strength in a variety of non-energy sectors.

Through the last half of 2006 the trend for the biotechs (BBH) and airlines (AMR) was positive. In January of 2007 the trend shifted back to energy with a particular focus on gasoline prices and the refiners (VLO). Through the second half of 2007 the trend included a melt down in the financialsand offsetting strength in the gold miners (ABX) while the first half of 2008 was dominated by coal and natural gas (CHK) producers.

Sectors that did well during the second half of 2006 are showing strength this month. The biotech etf and AMR have broken out while Cisco (CSCO- shown below) has made an upward pivot in response to weakness in metals and energy prices that is definitely reminiscent of August of 2006. If history were to be kind enough to repeat tech, telecom, pharma, biotech, and even the airlines should resolve higher into January of 2009.



Equity/Bond Markets

We are going to take another run at an argument that we introduced in yesterday’s issue. At top right we show a comparison between 3-month eurodollar futures and the stock price of Merrill Lynch (MER) from 1998.

If there has been one constant in the markets since the early 1980’s it has been that each time central banks raise interest ratesfor any length of time one or more markets explode into a crisis which, in turn, leads to a decline in interest rates and an easing of credit.

After escaping almost certain doom central bankers are then loathe to tighten credit conditions post-crisis which allows the markets to create yet another asset price bubble. The tech/telecom/internet bubble into 2000 was, at least in part, a function of the hesitancy by central bankers to raise interest rates aggressively so soon after the Asian/LTCM/Russian/Brazil crises between late summer of 1998 and the first quarter of 1999.

As the Asian crisis hit the markets in the autumn of 1998 the stock price of Merrill Lynch began to crater. We show MER along with 3-month eurodollar futures to make the case that the ‘crisis’ helped pushdebt prices higher as short-term interest rates declined.

If the purpose of a crisis is to remove central banks’ collective feet from the brake and get them back on the monetary accelerator then the recent subprime debacle worked quite nicely- to a point. The Fed responded aggressively and U.S. short-term interest rates most certainly moved lower but the ECB- which works off a single mandate to hold inflation in the euro-zone below 2%- failed to respond. In fact each time the Fed lowered interest rates the dollar would decline which would push commodity prices higher adding upward pressure on European interest rates.

The chart at middle right compares FreePort McMoRan (FCX) with 3-month euribor futures. In this example we are comparing the stock price of a commodity producer (FCX) with short-term European debt prices.

Our thought is that the financial system is so highly levered that it simply can not function for any length of time without ample supplies of relatively cheap credit. Our thought is that since the ECB failed to blink when faced with the prospect of systemic risk rolling through the majorbanks the markets have to move on to something new. Our thought is that the next crisis could occur in the commodity markets which would, in turn, drive the share price of FCX down into October in a manner similar to MER back in 1998. If so… then we will know that the markets have found the appropriate lever once 3-month euribor futures prices begin to rise similar to eurodollar futures towards the end of August in 1998.

At bottom right we have included a chart comparison between Genentech (DNA) and Japan’s Mitsubishi UFJ (MTU).

For good or for bad this makes for an interesting comparison. DNA turned higher in 2005 ahead of MTU and then peaked in late 2005 some months in front of MTU. Now that the biotechs have swung upwards the argument is that the markets are setting up for a recovery in the financials that, we have previously argued, should go with a reduction in short-term yields in both Europe and then Japan.