by Kevin Klombies, Senior Analyst

Wednesday, September 26, 2007

Chart Presentation: The Commodity Theme

Going back more than three decades there have only been two major peaks for the commodity theme. The first was during the third quarter of 1981 while the second occurred during the third quarter of 1994.

At right we show a comparison between the stock price of Coca Cola (KO) and the ratio between the stock price of Phelps Dodge (PD) and the S&P 500 Index (SPX).

PD was taken over by FreePort-McMoRan (FCX) so the data only runs to this past April. However this should suffice for our purposes today.

Back in 2002 and 2003 we ranted almost daily about out expectations for a major rally in the commodity theme. Day after day we diligently wrote that we liked all things ‘commodity cyclical’. One of the reasons can be seen through the PD/SPX ratio. Our argument was the markets go through long swings or cycles that, over time, adjust relative prices.

The commodity theme peaked in August of 1981 and then again 13 years later in September of 1994. If history were to repeat the forecast peak for the commodity theme would be some time during the third quarter of 2007. In other words… right about NOW.

The charts below right show the SPX through 1981 and 1982 as well as the SPX from 1994 through 1995.

The end of the commodity theme in 1981 preceded a major equity bear market that extended through into August of 1982 while the peak in 1994 led to some markets choppiness through into December and then a monster bull market. In both cases the markets essentially rotated out of commodities and into large cap consumer names like KO. The purpose of the chart comparison at top right is to show that following the peak in the PD/SPX ratio the stock price of KO began to trend upwards.

We suppose our point is that a weaker commodity trend can and has led to a recession and bear market and it can also presage a major bull market. The difference between 1981 and 1994 was likely the length of time BETWEEN the peak in the commodity theme and the start of falling short-term interest rates. Short-term yields started to decline in the summer of 1982 and again in December of 1994 and in both instances this led to a rising equity market. In the current situation short-term interest rates have already turned lower so one could argue for a much smoother and less painful transition this time around.


Months (and months) ago we introduced the argument that after the Fed cuts the funds rate for the first time the stock prices of Boston Scientific (BSX) and Lear Corp. (LEA) tend to swing higher. With a bit of a lag the same thing is often true with regard to lumber futures but that is an issue for another day.

Now that the Fed- rightly or wrongly- has made the first reduction to the funds rate we are going to do our best to keep tabs on the BSX argument. The long view is that once BSX turns higher it tends to trend upwards for about 3 years. The shorter view is that through the last two cycles the stock price of BSX has risen until the ratio between Exxon Mobil (XOM) and BSX has declined to around 4:1.

The chart at right shows BSX and the XOM/BSX ratio which declined yesterday to around 6.5:1. The best case for BSX might be that XOM remains at or even above its current share price of 91.73 because BSX would then have to rise to around 23 to pull the ratio back to 4:1. Our thought was that we would expect something closer to 80 and 20 towards the end of the year and are naturally hoping that it doesn’t turn out to be more like 60 and 15 instead. We have included another perspective on page 5.

We have a number of intermarket relationships that we use with regard to the stock price of Wal Mart (WMT). Below and below right we show WMT along with the product or combination of crude oil futures prices times the Australian dollar (AUD) futures.

The basic argument is that WMT trends inversely to the cyclical commodity theme so it will tend to trend flat to lower as long as oil prices and the commodity currencies are rising. The last major upward pivot for WMT occurred at the start of the first quarter in 1997.