by Kevin Klombies, Senior Analyst

Monday, October 1, 2007

Chart Presentation: Rotation

We start out today with a comparison between the stock price of Merck (MRK) and that of Intel (INTC) from 1998 into 2002.

From the mid-1990’s forward the major trends included a strong U.S. dollar and consistent out performance by large cap U.S. stocks as commodity prices weakened. The ratio between financials like JP Morgan Chase (JPM) to copper producer Phelps Dodge (PD) rose steadily from late 1994 into 2000.

At the tail end of the trend many of the consumer stocks- including names like Coke and Merck- started to tire and in response the markets narrowed focus so that much of the strength was concentrated within the tech sector. In other words as MRK’s stock price began to flatten out towards the end of 1998 the stock price of Intel began to rise almost parabolically. Within the context of a strong dollar/large cap trend the markets through money at any stock or sector capable of sustaining earnings growth.

Between 2000 and 2007 the trend reversed away from the dollar and the large caps and back to commodities and foreign markets. The JPM/PD ratio moved lower so that by 2007 prices were back to the same relative levels as 1994.

The trend has largely been focused on the commodity theme but as the CRB Index reached a peak in 2006- similar to the top for MRK in 1999- the focus then shifted towards Asian growth. Our point is that the parabolic rise in the Hong Kong stock market this year appears similar to that of the tech and telecom sectors into the 2000 peak.




Equity/Bond Markets

Our page 1 point was that the strength in the Asian markets appears to reflect an aging of the trend. Money is chasing an ever-narrowing list of sectors that are capable of showing positive growth in a rising currency environment. The strong dollar eroded earnings momentum in one sector after another during the late 1990’s until only the tech and telecom sectors were left standing.

Eventually the entire trend came to an end but only after stocks like Intel and Cisco had reached a top.

We have argued from time to time that the stock price of Wal Mart (WMT) seems to trend inversely to that of the Asian theme. When the Chinese stock market cracked lower this past May it went with a rather impressive but short-lived rally in WMT. Once the Shanghai SE Composite Index steadied out and turned higher in July the stock price of WMT sank back below its moving average lines.

Our thought is that the strong U.S. dollar last decade reflected the strength of the theme but also acted as a cyclical offset or negative for that theme. The weak U.S. dollar this year reflects the fact that money is chasing growth elsewhere but will also serve to support and enhance the earnings and growth of U.S. shares. In other words… the weaker dollar is a short-term negative and a rather substantial longer-term positive.

Below are two charts of copper futures and the spread between 10-year and 3-month Treasury yields. The chart below right covers the time frame from late 1997 into 2001.

Quickly… when the spread declines below ‘0’ it reflects a negative yield curve and this is supposed to act as an offset or brake on cyclical growth. Ideally the yield spread begins to widen once cyclical growth as turned negative and typically this goes with lower copper prices.