by Kevin Klombies, Senior Analyst TraderPlanet.com

Monday, February 04, 2008

Chart Presentation: Struggling Trends

We would like to go back over one of the arguments that we have been struggling with of late. Long-time IMRA readers will likely recognize that this is one of our tendencies as we worry over the details that aren’t fitting in instead of appreciating those that are.

Going back to 2007 we argued that when the Fed started to finally cut the funds rate it should mark the bottom for stocks such as Boston Scientific (BSX) and auto parts maker Lear (LEA) followed a few months later by lumber futures. Our sense, however, is that this has less to do with the decline in short-term interest rates and more to do with the reason yields are falling.

At right are two charts of Boston Scientific, the yield index for 3-month U.S. TBill yields, and the product or combination of crude oil futures times natural gas futures. The top chart is from 2000 through 2001 while the lower chart begins in the spring of 2007.

The bottom for BSX was made in December of 2000 as short-term interest rates began to decline so our thought was that when yields finally turned lower in 2007 it should mark the lows for BSX.

The problem, however, was that the driver behind falling interest rates in 2000 was much different than that of 2007 because the trend in the former instance was caused by cyclical weakness while in the latter it was weakness in the financials in the face of cyclical strength.

To adjust for this we have included energy prices (crude oil times natural gas) into the mix. As yields began to decline at the end of 2000 marking the start of a positive trend for BSX we note that energy prices began to decline.

Our sense as we pondered this relationship was that the ‘roll’ back into BSX would likely require two things. First, weakness in energy prices and second, an appropriate point in terms of ‘time’. In other words major trend changes tend to take place around the start of new quarters and especially around the start of new calendar years as money moves away from the previous year’s trend in search of something new. Coincidence or not we find that energy prices are starting to show weakness early in the new year even as BSX shows indications of turning higher. If all goes well we will remain positive for BSX for the next 2 to 3 years while looking for indications of strength in lumber futures prices later this quarter.

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Equity/Bond Markets

We showed the comparison between crude oil futures and the ratio between Boeing (BA) and Wal Mart (WMT) in a recent edition. The idea was that this ratio tends to trend with crude oil prices because BA trends with the cyclical trend that includes rising energy prices while WMT tends to rise after energy prices turn lower.

At right we show the comparison but have shifted or offset the charts by one quarter. The idea is that trends within the equity markets are actually running about 3 months ahead of the commodity markets.

For good or for bad the argument is that the BA/WMT ratio turned higher in the autumn of 2006 and ran to a peak 12 months later at the end of the third quarter of 2007. Crude oil prices, on the other hand, bottomed in January of 2007 and pushed higher for 12 months through the end of the year. What intrigued us, however, was the extent of the initial correction in the BA/WMT ratio because it suggests the potential not only for lower crude oil prices into April but also for markedly lower oil prices. In other words based on this chart we could justify a return to 50- 60 crude oil into the second quarter which, we suspect, would do wonders for the non-energy equity markets sectors.

Below are two charts of Fannie Mae (FNM) and the CRB Index. The lower chart runs from 1988 through 1991 while the chart at bottom right starts in late 2005.

The CRB Index made a peak in 1988 followed by a second peak in late 1990 that went with the end of downward pressure on the financials. Our quick thought was that the current cycle is somewhat similar in that the CRB Index topped in 2006 and then rose to a second top in early 2008 in the face of definite weakness in the financials. The key to a recovery in the banks and brokers will likely come from commodity price weakness through 2008.

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