by Kevin Klombies, Senior Analyst

Tuesday, December 18, 2007

Chart Presentation: THE TBONDS

With the S&P 500 Index now below the 200-day e.m.a. line the equity markets are in search of a ‘driver’ to help lift the trend. This is where things will get truly interesting because generally the ‘driver’ would come from lower energy prices, interest rates, and a rotation into the more defensive sectors before falling energy prices would revitalize the non-energy cyclicals. The twist is that the equity markets were in much the same position last August and in response crude oil prices rallied by roughly 30 points. We will cover the set up in more detail on page 5 today.

Returning to one of our ‘macro’ views we show once again the ratio between the stock price of Phelps Dodge (PD) and the S&P 500 Index (SPX) at right along with U.S. 30-year T-Bond futures and then feature the ratio between FreePort-McMoRan (FCX) and the SPX below right.

The big picture argument is that every thirteen years the stock prices of the commodity producers reach a relative strength peak. This happened in 1981 and again in 1994 with the third instance taking place around the end of October this year.

At the peak for the PD/SPX ratio the bond market began to lift. In other words the response to the peak for the commodity trend within the equity markets was lower long-term interest rates.

The TBond futures rallied nicely through 1982 before eventually reaching a peak towards the end of 1986. This bond price peak marked the low for the PD/SPX ratio.

In a similar manner the bond market bottomed around the end of 1994 as the PD/SPX ratio topped out. The commodity theme remained generally negative through 2001 which helped to support the trend towards lower interest rates.

The point is that the recent peak in the FCX/SPX ratio makes the case for a better bond market. If history repeats the TBonds should be nicely stronger into the fourth quarter of 2008 because following the PD/SPX peaks in 1981 and 1994 the TBonds enjoyed a positive trend for the next 12 to 15 months. After that the bond market would be expected to show some amount of strength until the commodity trend finally reaches its next bottom. Once again- if history were to repeat- that would occur roughly five years from now.



Equity/Bond Markets

We do not know whether anything is ever ‘normal’ with regard to the financial markets but we do know that the reaction or outcome this past August was likely something other than ‘normal’. Now we are going to have to do our best to explain what we mean by this.

At right is a chart of the SPX, the stock price of Caterpillar (CAT), and the pharma etf (PPH) from 2006.

We have argued that the SPX declines with CAT and rises with the PPH. In other words the break in the SPX during May and June of 2006 was marked by weakness in the stock price of CAT which preceded weakness in commodity prices. The SPX then rose from July into August as the consumer, health care, financial, and tech sectors started to recover.

The chart below right shows the same comparison for 2007. Once again the SPX broke to the down side in July on weakness in the stock price of CAT. What is was ‘supposed’ to do was gradually build back to the upside on rising pharma stock prices. Notice, however, that the PPH has done little more than chop back and forth around the moving average lines and it is this behavior that has made the markets so frustrating over the past six or so months.

Below we show the stock price of AMR along with the PPH.

In 2006 the PPH bottomed in June and broke to new highs in August. As this happened oil prices turned lower and the stock price of AMR began to recover.

The point is that in what we would view as a ‘normal’ market cycle the initial weakness comes from the commodity cyclicals followed by lower interest rates and a recovery in the consumer and pharma sector. Once this recovery has done its initial work the trend then shifts to lower energy prices and a recovery in the non-energy cyclicals.

The problem this year- as we will attempt to show on page 5- is that the markets set up perfectly into late August only to have crude oil prices increase by another 30 points with rather severe consequences.