by Kevin Klombies, Senior Analyst

Monday, September 15, 2008

The Euro(below) bounced nicely on Friday pulling money backtowards the commodity markets. One of our views is that around the time the 50-day e.m.a. line ‘crosses’ through the 200-day e.m.a. a bottom of some sort is usually formed. If the euro is actually in a strong and rising trend then it will push back towards and then through 1.50. On the other hand a negative trend tends would be confirmed if the recent lows are ultimately broken.

At top right we show the CRB Index along with an annual percentage Rate of Change (ROC) indicator for the time period between 1999 and the end of 2001.

The Fed began to cut interestratesin January of 2001 ahead of actual weakness in the CRB Index and some months before commodity prices went negative on a year-over-year basis.

Below right we show the same comparison from the end of the third quarter of 2006 to the present day.

The major difference between the Fed and the ECB is that the former’s mandate includes both inflation and economic growth while the latter’s is focused only on the inflation rate. This means that the Fed will tend to raise and lower interest rates faster than the ECB. Our thought is that short of a new round of Euro-concentrated banking problems it might well take the CRB Index going negative on a year-over-year basis before the ECB finally relents and begins to reduce interest rates.




Equity/Bond Markets

The chart below compares the U.S. 30-year T-Bond futures with the S&P 500 Index (SPX).

On Friday both the dollar and the TBonds fell fairly sharply. We have been focusing of late on the close proximity to the January and March highs for the TBond futures. The argument was that a number of key equity ‘bull’ markets have begun as bond prices broke out through resistance.

The other argument was that each of the last four short-term bottoms for the SPX have been made at a peak for bond prices. The chart shows that in November of last year as well as January, March, and July of this year the equity markets began to rally once bond prices turned lower.

We spent much of last week showing the relationship between bonds and the SPX because the TBonds had pushed up to 121. From the stand point of the equity markets new highs for bond prices would support our view that we should continue to focus on the consumer defensive and health care themes. On the other hand a sharp decline in bond prices- as was the case on Friday- would serve to reinvigorate the cyclical themes.

We have used the term ‘cyclical themes’ for a reason. Weaker bond prices and rising interest rates tend to go with strength in the cyclical sectors while a stronger dollar will tend to be better for the non-commodity sectors. In other words weaker bonds with a stronger dollar would tend to be a positive for the autos, airlines, Japan, tech, and even many of the financials. Weaker bonds with a weaker dollar, on the other hand, would funnel money into the commodity themes. While it was only one day of trading we couldn’t help but notice the strength in names such as Potash and FreePort McMoRan (definite commodity cyclicals) even as the share prices of Apple and Research in Motion weakened.

Our view, by the way, is that we will see new highs for the TBond futures into October.

Below we show the SPX along with crude oil futures.

A few weeks ago we ran an old chart of Alcan (AL) to make a simple point. When the commodity cyclicals are weak into the autumn they tend to make major bottoms into October.

We have also argued on more than a few occasions that the markets tend to trend from quarter to quarter. The chart at right makes the point that crude oil futures prices began to trend lower in early July while the SPX began to trend higher at the same time.

The point is that if both trends run through the quarter and into the first half of October then we could see crude oil futures prices between 70 and 80 while the SPX could, in theory, push as high as 1500- 1530.

To summarize when the commodity cyclicals are weak at this time of year it usually makes sense to look for a bottom around the second half of October. The equity market’s reaction to falling commodity prices will vary from cycle to cycle but the initial response from July into August was positive so there is still a chance that we could see 1350 and then 1400 challenged as we move into the fourth quarter.