by Kevin Klombies, Senior Analyst

Wednesday, December 12, 2007

Chart Presentation: Rolling Over

The equity markets tumbled yesterday after the Fed cut both the funds and discount rate by 25 basis points. Apparently the markets were hoping for a bit more than the Fed was willing to provide including a larger reduction in the discount rate along with lower reserve requirements.

One of our theses has been that the equity markets decline with Caterpillar and rise with pharma. By this we mean that downward pressure begins with cyclical growth which causes interest rates to decline and then upward pressure is created as pharma and consumer defensive sectors lift. To the extent that the commodity sectors were starting to show relative strength as crude oil prices pushed above 90 a bit of a reality check did seem in order. We got one yesterday.

At right we show Canada’s Bank of Nova Scotia (BNS) and the NASDAQ Composite Index from 1999- 2000 and Japan’s Mizuho Financial (MFG) and crude oil futures prices from 2007.

This is yet another spin on the argument that we have been using for the last few weeks. The idea is that the offset to the rise in the NASDAQ into March of 2000 was an outflow of money away from non-U.S. financials. In other words the cyclical trend evidenced by the rise in the NASDAQ Comp. pulled money towards the U.S. and pushed interest rates higher to the detriment of the share prices of non-U.S. financials.

The bottom for the share prices of Canada’s banks were made at the very peak for the NASDAQ in early March. The BNS pushed up towards the 200-day e.m.a. line and found support during daily corrections on the 50-day e.m.a. line. Eventually the NASDAQ broke below its 50-day e.m.a. line at the end of March and the BNS lifted upwards.

Our surrogate for the NASDAQ in the current cycle is crude oil futures prices and instead of the Canadian banks were are concentrating on Japan’s banks because the yen has clearly been one of the key ‘sources’ of capital over the past few years.

The bottom for MFG was reached in early November as crude oil prices made the first push towards 100. Now we find crude oil futures holding around the 50-day e.m.a. line as MFG dips back to its 50-day e.m.a. line. Through trading yesterday the process of creating a top and then rolling over to the down side appears to be progressing in a reasonable manner.



Equity/Bond Markets

We are going to make an attempt to show why we felt that yesterday’s equity markets drubbing actually made sense. To do so we have included two comparative charts at right that feature, from top to bottom, the ratio of the Amex Oil Index (XOI) to the S&P 500 Index (SPX), the sum of the share prices of Caterpillar (CAT) and Valero (VLO), and the stock price of airline AMR. The top chart shows most of 2006 while the lower chart is from 2007.

We have argued in the past that the lows for both the home builders and the airlines (we show U.S. home builder Hovnanian (HOV) below) should be made around the time that crude oil prices and the XOI/SPX ratio move below their respective moving average lines. In other words the markets have to move away from pushing crude oil prices higher and concurrently chasing the oil-related stocks upwards before it is time to rotate out towards those sectors that are negatively impacted by rising energy prices.

We have been using both CAT and VLO as surrogates for the trend for energy prices. CAT tends to turn lower before crude oil while VLO is more closely tied to gasoline prices and refining margins.

In 2006 AMR turned upwards just after the XOI/SPX ratio broke below the 200-day e.m.a. line and on almost the same day the sum of CAT and VLO broke down through the June lows. Our expectation was that we would still require additional cyclical weakness that included falling energy prices before the home builders and U.S. airlines would join the party.

The problem this year has been that crude oil prices remain ‘too strong’. In early trading yesterday the explanation for crude oil prices pushing up through 90 was that the markets believed that the Fed would cut interest rates aggressively enough to avoid a recession. Chart-wise we could see that in late November into early December the stock price of AMR was declining as the sum of CAT and VLO moved higher. Our argument was that we needed lower oil prices and much less confidence with regard to the commodity-oriented cyclicals so that the process of working through a recovery could proceed at the pace and in the manner that we have been anticipating. To that extent the equity markets dumped- rather impressively, actually- which helped to slow the rise in oil prices and the recovery in CAT and VLO. To get the turn in the airlines and home builders, however, will require crude oil futures moving below- at minimum- the 77 level. All of which leads us up to the point that we get the weekly energy inventory numbers today.