by Kevin Klombies, Senior Analyst

Monday, February 25, 2008

Chart Presentation: The (Really) Bullish Case

When a security or market drives higher day after day after day we tend to view this as coming back ‘on trend’. The same is true for ‘crashes’ but for today we are going to concentrate on the sunnier side of the equation. In so doing we are likely going to contradict much of what we have written over the past while but… it makes for an interesting thesis all the same.

The rise in commodity prices since early 2007 has all the ear marks of a market coming back ‘on trend’. In other words when a security or market is in an ongoing positive trend but gets pressured lower for a period of time it has to rise at an accelerated pace to return to the original trend. The chart at right of the CRB Index certainly makes the case that the relentless price rise represents the commodity markets returning to the original positive trend that began in late 2001.

This gets even more interesting when we compare the CRB Index chart to that of the S&P 500 Index. Since commodity prices bottomed at the end of 2001 one full year ahead of the equity markets we have offset or shifted the charts at right by twelve months. In other words we are comparing the CRB Index through 2002 with the SPX during 2003 and so on.

Commodity prices pivoted upwards at the end of 2001 and surged quite sharply through 2002. One year later the SPX bottomed and turned higher before driving upwards for a full year through 2003. So far, so good.

The standard argument is that the equity markets discount the future and in so doing lead the real economy so one would expect the SPX to swing higher and lower in advance of the CRB Index. This argument is backwards, in a sense, because it suggests that the commodity markets represent the underlying trend with the equity markets lagging behind by a considerable and consistent length of time.

The CRB Index peaked in the summer of 2006 and then collapsed through the second half of the year. If our thesis were to hold water the equity markets would have to top out in the summer of 2007 and then crumble well ‘below trend’ into early 2008. Strangely enough that is exactly what has happened which, in turn, suggests that global economic growth and the trend for the equity markets is in some way dependent upon rising commodity prices.



Equity/Bond Markets

Concurrent with the weaker equity markets trend we have seen rising bond prices/falling interest rates and rising commodity prices. When markets trend so closely together it is easy to view the relationship as ‘causal’. In other words rising commodity and bond prices must be a negative for equity prices because we are seeing commodity and bond prices strength at the same time the equity markets are declining.

Below we show the SPX along with the CRB Index multiplied by the price of the 30-year T-Bond futures from 1980 into 1984. The idea is that if rising bond AND commodity prices are a negative for equities then when the product of the CRB Index and TBonds futures swings higher the equity markets should decline. Not so. Not even close to being so. In fact we have argued in these pages in the past that the most intensely bullish equity markets trends have taken place when commodity and bond prices are rising in tandem.

The equity bull market that began in 1982 coincided with a return to a rising trend for commodity and bond prices. The same was also true at the end of 1994 as the combination of commodity and bond prices turned higher at the start of what was to be a 5 to 6 year equity bull market. In other words falling interest rates help support and raise valuations while strong commodity prices suggest underlying cyclical growth and when both are strong and rising the equity markets tend to rise in response.

If the premise is that the SPX should trend with instead of against the combination of the CRB Index and TBond futures then we would be well served to view at least one of the instances where, in the past, the trends diverged. Such was the case through 1987 as shown below. The SPX continued to rise well after the combination of bond and commodity prices turned lower which in turn helps to explain first why the equity markets ‘crashed’ in the autumn of 1987 and second why following the recovery in bond prices the equity markets returned to a positive trend in 1988.

At present- chart at bottom- the CRB Index times TBonds futures combination is not only strong and rising but it is at record highs. Not only is the underlying equity markets trend positive but it is so positive that it makes us wonder whether something like 1700 for the SPX in the first quarter of 2009 is being overly conservative.