by Kevin Klombies, Senior Analyst

Friday, March 7, 2008

Chart Presentation: Sprinting Lower

On quite a few occasions over the past months we have argued that the equity markets go down with Caterpillar and up with pharma. The problem recently has been that the pharma sector has been almost dead in the water with each equity markets rally more a function of strength in CAT. Since CAT tends to lead crude oil prices- both higher and lower- the net result is that each bout of equity markets strength leads to ever higher energy prices.

When we use the term ‘up with pharma’ we are actually referring to something a bit more broad so to explain we are going to show two charts based on the stock price of Sprint Nextel (S). If there is one stock that really helps to show why commodity prices have been so strong it is likely S.

At top right we have included a comparison between S and the ratio between equities (S&P 500 Index) and commodities (DJ AIG Commodity Index) from late 1992 through into late 1995. In essence we are attempting to show the changes within the markets in early 1995 that led to the monster equity ‘bull’ that extended through into 2000.

The equity market underperformed the commodity market from the second half of 2003 through 2004 and this created or, perhaps, went with a negative trend for Sprint. In late 1994 we find S and the equity/commodity ratio at a bottom and as both turned higher the bull market began in earnest.

At present (chart below right) both the stock price of S and the equity/commodity ratio are in the midst of what appears to be an Acapulco cliff dive or, at minimum, a swan dive out of the branches of a tree outside of Rick’s Cafe in Negril, Jamaica. The point is that it is no surprise that S is weak because, after all, it is supposed to bottom with the equity/commodity ratio to mark the end of the old trend and the start of something new. To the extent that S continues to decline- the good news being that it only has about 7 points of down side before it hits zero- the commodity markets will outperform the equity markets.

We rarely (and by this we mean almost never) ‘count waves’ but we will make an exception in this case. We might be able to argue that S is some ways into the 5th or final wave of the corrective pattern which simply means that with a margin of error of about 7 points we believe that the stock price of Sprint Nextel is at a bottom.



Equity/Bond Markets

Below we show another chart based on the ratio of equities to commodities. In fact the first two charts that we are going to discuss on this page represent relationships that make the markets more complex than they really have any right to be at present.

All things being equal when interest rates decline equities ‘should’ outperform commodities. This is because interest rates tend to decline during periods of economic slowness and, surprisingly enough, commodity prices tend to decline when the economy softens. Not so at present, of course, but that is the general rule.

The markets are somewhat ‘upside down’ these days as a declining equity/commodity ratio goes with falling 10-year Treasury yields and not the other way around. From 2000 into 2008 the equity/commodity ratio as traded up and down with instead of against yields. Our point yesterday was that if the TBonds hold at or below the 120 level (and this might get an good test following today’s U.S. employment report) then the SPX should be at a bottom (give or take, of course, about 1300 points on the SPX).

Below right we show the CRB Index and the ratio between Coca Cola (KO) and the SPX from early 1980 into late 1983. The point is that when the markets are working the way they are ‘supposed’ to work the KO/SPX ratio will rise during periods of cyclical weakness exemplified by declining commodity prices. Imagine our confusion at present because we are fully aware that the KO/SPX ratio turned upwards in early 2006 and remains in a rising trend even as crude oil prices and the CRB Index make new record highs.

Below- quickly- we show the U.S. 30-year T-Bond futures and the sum of… 3-month eurodollar futures (which are priced at a discount to 100) and the Fed funds target rate. When the two added together equal more than 100 this means that the over night yield is higher than the 3-month eurodollar yield so using two moving average lines… we find that bond price peaks tend to occur when the moving averages lines rise about the 100 level. For the first time since mid-2003 this chart is indicating that a bond price peak is due (either at 120 or, if taken out, then closer to 125).