by Kevin Klombies, Senior Analyst

Thursday, July 5, 2007

Chart Presentation: Thesis Review

We are quite sure that there are simpler ways to show today’s Chart Presentation but since we haven’t used this particular perspective in quite some time we are going to do our best to make some sense out of chart at right.

The chart, from bottom to top, consists of a combination of Canadian and U.S. short-term debt prices, the sum of copper and crude oil futures prices, and an annual percentage Rate of Change for the S&P 500 Index. Obviously this is going to require an explanation.

We are using a combination of Cdn and U.S. debt prices by taking one half of the price value of 3-month Canadian Bankers Acceptances futures and one half the value of 3-month eurodollar futures and adding them together. The idea is that a confirmed trend change in short-term debt prices should include a rising or falling trend for the sum.

We have added copper futures (in cents) to three times the value of crude oil futures (in dollars). This sum tends to rise and fall with interest rates so at its peak we should also see a bottom for the sum of the short-term debt futures prices.

The annual Rate of Change (ROC) indicator shows the percentage change in the S&P 500 Index from one year previous. When the line is above ‘0’ the change is positive meaning that the U.S. equity market is higher than one year earlier and vice versa.

One of our BIG arguments has been that at the peak for copper and crude oil we will be at the bottom for short-term debt prices. In other words at the peak for energy and metals prices we will be at the top for short-term yields. The argument then was that once we reached the peak in yields, energy prices, and metals prices the equity markets should ‘drive’ for at least the next twelve months.

From 1990 into 1991 the ROC pushed upwards and through 1995 it also resolved higher. From 2000 into 2001 the indicator moved lower. In each case the change in the ROC was at least ‘40%’. For example it swung from less than -10% in 1990 to more than +30% in 1991.

In mid-2006 the sum of copper and crude oil hit a top and the sum of the short-term debt futures reached a bottom with the annual ROC indicator right at the ‘0’ line. The thesis was that this should lead to a change- either higher or lower- of roughly 40% in the value of the SPX over the ensuing twelve months.


Equity/Bond Markets

The S&P 500 Index is currently struggling near the highs of 2000 so getting from 1525 to 1750 this month is going to be somewhat difficult. If there is any chance at all of this happening we suspect that consumer stocks like Coca Cola (KO) will have to push sharply higher. We show KO and the SPX below. If KO breaks up through 53.65 then the positive trend remains intact but a break back below 51 opens up an outcome similar to 1997 that we discuss on page 5.

The argument was that the peak for commodity prices goes with the peak for interest rates which, in turn, creates a strong trend for the equity markets.

We then argued that this would go with a rising trend for equities relative to commodities and used the stock price of Schering Plough (SGP) as a surrogate for the trend. The chart at right shows that we were absolutely right (surprisingly enough) as the SPX/commodity ratio turned upwards in July of 2006 along with SGP as TBill yields began to trend sideways.

What we got wrong- and to this day we can hardly believe how badly we handled this- is shown at bottom right using the ratio of the oils (XOI) to the broad market (SPX) along with the CRB Index.

Our thesis was that commodity prices had peaked and that has certainly been the case when we view the trend for commodity prices through the CRB Index. Our thesis was that equities would outperform commodities and that has most certainly been the case. What we didn’t account for, however, was the way the commodity cyclical stocks (the ‘oils’ in this example) would outperform the broad market during those periods when commodity prices were rising within the negative trend.

The XOI/SPX ratio fell with the CRB Index for six months between July 2006 and January 2007 and then rose back to the old highs between January and July of this year. We got the absolute trend for the equity markets right and the relative trend within the markets quite wrong.