by Kevin Klombies, Senior Analyst

Monday, June 11, 2007

Chart Presentation: Tech and Biotech

It is often difficult to explain or even understand what the financial markets are doing because even the simplest relationships are based on two-handed concepts. For example, on the one hand falling interest rates are always a positive for equities because valuations are expanded but on the other hand declining interest rates quite often go with weaker stock prices. Rising interest rates are always a negative for equities but at the same time equities tend to do very well when rates are rising.

If we could come up with the simplest of rules it might be something like this. One wants to be long those sectors that are making interest rates rise and never long those sectors that are making interest rates decline.

In a positive cyclical environment with expanding earnings and rising asset prices interest rates typically trend higher. The strongest sectors create the most upward pressure on interest rates. In a negative cyclical environment with collapsing earnings and falling asset prices interest rates tend to decline with the weakest sectors putting the greatest downward pressure on yields.

In general the equity markets do well when interest rates are trending higher because this tends to happen during periods of strong cyclical growth. On the other hand at the very moment when interest rates are rising equities tend to do poorly. Often the best stock market rallies occur during those times when interest rates are moving lower within a rising interest rate trend.

In any event on Friday the equity markets responded positively to the earnings of National Semiconductor just after the Philadelphia Semiconductor Index (SOX) apparently broke down through the bottom of its rising trading channel. The markets also found a reason to like biotech after Genentech was upgraded by Deutsche Bank the day after the biotech etf (BBH) apparently broke through the bottom of its trading channel.

Our sense was that it was about time for energy and metals prices to turn lower because the strength of this trend was creating extreme upward pressure on interest rates and enough downward pressure on the non-commodity sectors to put the rising trends at risk. Our sense was the markets were so far out of balance that it was time for energy and metals prices to weaken to take the immediate pressure off of yields and allow the equity markets to rotate out of commodities and back into some of the other sectors that have largely been neglected this year.



Equity/Bond Markets

We show a chart of the combination of the Nasdaq 100 Index and copper futures.

Both the Nasdaq and copper are cyclical markets so in general they will trend higher and lower together. When the trend is positive there is upward pressure on interest rates and when the trend is negative there is downward pressure on yields.

The chart below shows copper futures, the Nasdaq 100 Index futures, and U.S. 3-month TBill yields from 1999 into early 2002.

Notice that TBill yields turned lower in late 2000 when both copper and the Nasdaq began to weaken. Into 2000 the cyclical trend was positive but dominated by ‘tech’ as the U.S. dollar pushed higher. Into 2006- 2007 the cyclical trend was positive but dominated by energy and metals prices as the U.S. dollar resolved lower.

Our argument is that within any positive cyclical trend there will be periods of time when the markets shift strength from one sector to another. We have shown in past issues that the biotechs and techs can take the lead when the commodity sector starts to weaken and quite clearly groups like the airlines take a turn whenever energy prices turn lower.

Below we show Texas Instruments (TXN) and National Semiconductor (NSM).

We have been looking for ‘gaps’ in the charts of non-commodity stocks because this tends to mark trend change points within the overall trend. On Friday the share price of NSM ‘gapped’ higher in response to earnings and our thought was that this indicated that the markets were finally ready to move away from the commodity/weak dollar theme and back towards those cyclical sectors that go with a better dollar.