by Kevin Klombies, Senior Analyst

Monday, August 27, 2007

Chart Presentation: Resistance

The lesson learned this month is that derivatives are useful for hedging market risk, sector risk, and security risk but they fail when it comes to liquidity risk. Fortunately the major central banks stepped forward to provide additional liquidity so once again the computer models appear free to fire away at even the riskiest asset classes.

The problem, we suppose, is that the reason for the crisis- weakness in the U.S. housing market coupled with almost criminally lax credit standards over the past few years- hasn’t gone away. There remains the potential for a couple of million home foreclosures and a couple of hundred billion dollars worth of subprime mortgage losses so, for all intents and purposes, this go around may be the first of many.

Our basic view is that the U.S. economy shifts from consumer driven to capital spending driven on occasion. When the tech cycle ended in 2000 easier credit conditions helped fuel a new consumer spending cycle and in the days, months, and years to come the Fed’s attempts to staunch the bleeding in the housing market will lead to an offset through increased capital spending.

In the face of impending doom one wonders how the equity markets manage to screw up enough conviction to push higher. Today we wanted to show two chart comparisons that help- we hope- to add some form of perspective.

We show the S&P 500 Index (SPX), Cisco (CSCO), and IBM through early 2007. We have argued on occasion that those stocks that were forced lower in early 2004 are now working back to those levels. For IBM the target was 100 while for CSCO it was roughly 29. Notice that when the stock prices finally reached these levels and stopped rising the SPX slowly began to lose momentum. After the February sell off both IBM and Cisco steadied and then moved on to new highs.

The chart shows the SPX, Anheuser Busch (BUD), and the pharma etf (PPH). BUD and the PPH (along with Coca Cola) reached the critical 2004 resistance line in May and June and similar to IBM and Cisco earlier in the year this led to a loss of momentum for the SPX and an eventual correction. Now that these stocks have washed out if history is any guide the rising trend should reassert itself leading to new highs later in the year.



Equity/Bond Markets

When the U.S. equity markets began to tumble back in late 2000 the catalyst was a sharp decline in capital spending in the tech and telecom sectors that was offset by lower interest rates. As interest rates declined consumers were able to refinance mortgages to increase spending. In due course the cycle was dominated by rising real estate prices and ‘flip this house’ home renovation projects.

The point is that years ago if one had known that the cycle was going to include consumer spending, strong real estate prices, and home renovations the obvious stock market ‘winners’ should have been stocks like Home Depot (HD). Instead the chart shows that HD has been mired in a declining trend since early 2000.

The chart at middle shows copper futures and an overlaid view of the ratio between the Morgan Stanley Consumer and Cyclical Indices along with (in green) the U.S. Dollar Index.

The idea is that the real dominant trend has been ‘cyclical’ and that this goes with both a weak dollar and rising metals prices.

The chart below shows the Canadian equity market (S&P/TSX Composite Index) and the ratio between large and small cap U.S. stocks (S&P 500 Index/NYSE Composite Index).

Similar to ‘cyclical’ versus ‘consumer’ the trend has featured prolonged relative strength in small cap versus large cap and non-U.S. compared to U.S.

The strange thing about the recent trend is that it has been driven by U.S. consumer spending but within the equity markets the best sectors have been non-U.S. and cyclical. The prevailing view seems to be that weakness in housing prices will slow consumer spending and lead to weakness in retailers like Wal Mart and Home Depot but perhaps it actually makes more sense to conclude that the real damage will done to the non-U.S. cyclical and small cap sectors.

The chart below shows HD scaled in semi-log. The argument here is that everything post-2000 actually represented a long correction within the rising trend that moved HD’s stock price from the upper channel line back to support. The weakness in the U.S. dollar, the shift to small cap and foreign, and the persistent strength in metals prices would then be mere by-products of a major theme in need of a consolidation.