by Kevin Klombies, Senior Analyst

Thursday, August 23, 2007

Chart Presentation: Return to 2004

In the spring of 2004 we began to argue that the Fed was holding interest rates ‘too low’ and that the markets would force rates higher by driving energy prices in general and gasoline futures in particular upwards. We recall making the wild forecast of $75 crude oil in one of our chart presentations during the second quarter of that year. Of course we also recall forecasting a return to something like $1.50 copper… but given our tendency to be well ahead of the markets perhaps this one will play out as well if we give it enough time.

In any event when energy prices began to strengthen in earnest in 2004 the Fed began the slow and almost torturous process of raising the funds rate by 25 basis points per meeting. Seventeen meetings later the funds rate reached its cycle peak of 5.25%.

One of our favorite arguments is that the markets literally ‘split’ during the first half of 2004 as commodity price momentum rewarded certain sectors and industries while the concurrent increase in interest rates acted as a negative for others. Put another way just over three years ago the flow of capital within the markets created rather clear winners and losers based in large part on commodity exposure.

The chart at top compares the stock price of Bear Stearns (BSC) and the sum of crude oil futures and U.S. TBill yields. For this chart a yield of, say, 4% would be shown as ‘40’.

The chart makes the point that BSC was one of the clear winners post-2004. Major dealers like BSC and Goldman Sachs found all kinds of ways to leverage exposure to the commodity-based trend including, unfortunately, subprime mortgage debt.

The chart below compares the Japanese yen futures with the Canadian dollar futures.

In 2004 the Canadian dollar began to strengthen while the yen reached a top. Canada’s exposure to oil, gas, lumber, metals, grains, etc. became a positive while Japan’s focus of using commodities to produce zippy consumer items became a negative. As a result the Canadian dollar has been a major winner over the past three or so years while the yen has declined rather significantly.



Equity/Bond Markets

We have argued on many occasions recently that the markets are now in the rather arduous process of reversing this trend. This simply means that the winners after 2004 are now working lower while the losers are struggling to push higher.

The chart shows Fannie Mae (FNM), Coca Cola (KO), and natural gas futures.

In trading yesterday natural gas futures hit 5.54 which is close to one third of the peak price reached at the end of 2005 and very close to the level which gas began to rise from back in 2004. In other words natural gas prices have gone ‘round trip’ while stocks like KO have done much the same thing but in reverse. Each time we look at FNM and its propensity to resolve higher our conviction in our argument increases. Stocks and markets pushed lower after the first half of 2004 are rising and sector that swung higher are now under pressure.

The chart comparison below shows two biotech companies- Amgen (AMGN) and Biogen (BIIB). This very specific example shows one biotech falling back to 2004 levels while another which was pressured lower rising at a relentless pace as it swings back to the highs of 2004.

The two stocks that come to mind that offer the best potential if this ‘return to 2004 levels’ continues would have to be Nortel (NT) and Boston Scientific (BSX). The problem is that we have a hard time being positive on NT even when the stock price is rising and BSX keeps hitting new lows.

The chart at bottom shows BSX and the U.S. 2-year T-Note futures. Notice that for well above trend as Bear Stearns is (page 1) the U.S. 2-year T-Notes are that much below trend. What has happened recently? Stocks like Bear Stearns start to crack and in response the short end of the Treasury market starts to rise as prices are squeezed back towards 2004 levels.