by Kevin Klombies, Senior Analyst

Friday, May 16, 2008

Chart Presentation: Things Go Better

We start things off today with a ‘macro’ perspective. The chart at right compares the stock price of Coca Cola (KO) divided by oil service company Schlumberger (SLB) with crude oil futures prices divided by the U.S. 30-year T-Bond futures.

By way of explanation we are using crude oil divided by the TBonds because this ratio marked not only the bottom for the S&P 500 Index (SPX) in 2006 but also- and more importantly- the lows for the SPX back in the autumn of 1990. In other words once oil prices finally peaked in October of 1990 long-term bond as well as equity prices turned higher.

What intrigues us about the chart comparison is the way the Coca Cola/Schlumberger ratio bottomed in 1990 around the .6:1 level (i.e. Coke’s share prices roughly 60% of SLB’s) at the peak for crude oil prices and then rose steadily to well over 3:1 by the end of 1998. The ratio, for all intents and purposes, helps define the trend. If the ratio is moving upwards, as it did from 1990 to 1998, then the trend is negative for energy prices while if the ratio is moving lower as has been the case since the end of 1998 the trend is positive for energy prices.

The chart argues that once crude oil prices finally reach a peak the next trend should favor consumer stocks such as Coke over energy price-sensitive names like Schlumberger. Put another way the ratio should trend higher and if history were to repeat then some years into the future Coke may well be 1.5, 2.5, or even 3.5 times the price of SLB.

Unfortunately the chart does not help us with the issue of ‘timing’. The KO/SLB ratio has been hovering around the lows for more than two full years which is in itself somewhat interesting because it helps explain why KO’s share price has been trending upwards with commodity prices. To the extent that the KO/SLB ratio has a floor around the .5:1- .6:1 level then each rise for SLB will be followed by a proportionate rally for KO.

While KO and SLB may be taking turns moving higher (chart on page 6) in the grand scheme of things this is all taking place within the context of a very powerful and positive energy price trend. Eventually this trend will turn negative- from these or higher levels, of course- which will then mark the start of a multi-year trend which should favor the large cap consumer names.



Equity/Bond Markets

Below is a comparison between the share price of Valero (VLO) and the ratio between crude oil futures and gasoline futures.

Towards the end of last year we began to argue that oil prices were so high relative to gasoline prices that one of the two had to break. Either crude oil prices had to decline or gasoline prices were going to rise. With U.S. gasoline inventories at the highest levels since 1994 it seemed logical to conclude that there was more down side to crude oil than upside to gasoline. Not so, however.

We are constantly amazed at the number of ways the markets find to keep the energy trend alive. When the weather gets colder natural gas prices rise along with crude oil. When gasoline inventories decline crude oil prices rise. When gasoline inventories are so high that the refiners can’t make any money turning crude oil into refined products… crude oil prices rise because of perceived potential shortages in heating oil. Amazing.

At bottom right we show the Nasdaq Composite Index along with crude oil times natural gas futures prices. Below we feature Hong Kong’s Hang Seng Index along with the crude oil times natural gas combination.

The argument here is that not only did the Nasdaq break well ahead of energy prices in 2000 but a few months before the Nasdaq reached its March peak energy prices began to rise. The combination of crude oil times natural gas turned higher in January and continued to push upwards through the balance of the year.

Our thought was that indices like the Hang Seng or Shanghai Comp. have shown a similar relationship to energy prices. The turn higher for energy prices last August preceded the peak in the Hang Seng by a few months so, if history were to repeat, the Hang Seng Index would now be in a similar position to the Nasdaq around the start of September in 2000.