by Kevin Klombies, Senior Analyst

Monday, July 2, 2007

Chart Presentation: Thesis

Let’s start things off with a simple statement: The markets are always right. If you find yourself disagreeing with the markets then you are wrong. If you believe that the markets are behaving irrationally then you have to step back and reconsider your thesis. Above all else the markets are ‘right’.

Our thesis has been that interest rates peaked in mid-2006 and that this would lead to at least 12 months of ‘driving’ equity prices. Since the initial reaction to lower yields was a rising equity market we concluded that the stock market would be higher at least into the summer of 2007.

The problem is that 10-year U.S. Treasury yields have risen back to close to last year’s highs. On the other hand the page 6 chart of the ratio between Caterpillar (CAT) and Coca Cola (KO) shows that for the time being the upward pressure on yields is abating.

The chart shows the S&P 500 Index (SPX) from March through August in 1990. The purpose of the chart is to show that it typically takes some time for a market to make a ‘top’. In 1990 the SPX made a series of peaked between 365 and 370 before resolving lower.

With this picture in mind we show at bottom the charts of oil refiner Valero (VLO), gasoline futures, and the sum of copper futures (in cents) and crude oil futures (in dollars multiplied by three times).

Through May and June these three markets essentially worked sideways. Our intermarket view is that the rising trend also goes with or represents a rising trend for interest rates.

Our view is that interest rates peaked around the end of the second quarter of last year but after a six month rally in the commodity markets we find interest rates back near the top once again. The argument recently has been that it often takes six to seven weeks for a market to finish a consolidation and that trend changes often swing around the start of a new quarter.

With the sum of copper and crude oil near the rally peak we suspect that we won’t have to wait for much longer to find out how this will resolve. Lower prices mean lower interest rates and a return to relative strength by the non-commodity sectors. An upside break out suggests a lower U.S. dollar, even higher interest rates, and a very serious re-think regarding our entire thesis.



Equity/Bond Markets

The chart shows the stock price of Cisco (CSCO) through the year 2000. The idea is that months before the market began to pull short-term interest rates lower (in November 2000) and even longer before the Fed recognized that it was time to ease monetary policy by cutting the funds rate (January 2001) the leading edge of the dominant cyclical theme- tech and telecom- began turn negative. Cisco’s stock price broke below the 200-day e.m.a. in September with the moving average lines ‘crossing’ to confirm the new bearish trend in October.

Below we show the stock prices of Bear Stearns (BSX) and Nucor (NUE) from the present time period. During the last month of the quarter (i.e. June) both BSX and NUE broke below their 200-day e.m.a. lines with the moving averages for BSX also ‘crossing’. Our view is that this represents the leading edge of the end of the cyclical trend that has been pushing Treasury yields higher.

Below we show Johnson and Johnson (JNJ) along with copper futures.

On occasion in the past we have shown this chart and argued that JNJ is trending inversely to copper prices. When copper prices were swing higher in February and March the stock price of JNJ was breaking lower.

At the end of June we find copper above its 200-day e.m.a. and JNJ below its moving average line. Strong copper prices go with rising interest rates and relative strength by JNJ represents a period of falling interest rates.

The point was that combinations like ‘crude oil and copper’ and markets like gasoline futures have been consolidating or topping for weeks. If this is a ‘top’ then copper prices should resolve lower with a more positive trend developing for JNJ. The weakness in BSX and NUE suggests the potential for cyclical deterioration sufficient to convince the markets and then the Fed that lower interest rates are required.