by Kevin Klombies, Senior Analyst

Wednesday, July 23, 2008

Chart Presentation: Trend Checks

A 3 point decline in crude oil pricesyesterday helped offset negative earnings reports to lift the U.S. equity markets and dollar. The Airline Index (XAL) flew to more than a 22% gain.

Intermarket analysis is based on the premise that one market impacts another. Strong crude oil priceslead to higher refined products prices which in turn leads to greater demand for ethanol which pushes grains prices higher.

uly 22 (Bloomberg) — Cotton fell to a two-week low on speculation that slumping corn prices will reduce the chances that farmers will switch crops in the U.S., the world’s biggest exporter of the fiber.

Weakness in energy prices, on the other hand, can lead to falling cotton prices at the same time thatshare pricesof the airlines and autos improve.

To get a sense of what may happen once the major trend changes we have to at least have a sense of what is happening as a result of the current trend. At top right we show the ratio between the S&P 500 Index and the NYSEComposite Index so that we can examine the relative strength of large cap U.S. stockscompared to smaller cap.

The tech, telecom, and internet ‘bubble’ favored the U.S. dollar and large cap U.S. equities from 1994 into 2000 before the ratio collapsed back to the starting point into early 2001. The next trend favored commodities and foreign currenciesand has run from the end of 2001 to the current time period. Our view is that there is a similar bubble in foreign currencies, foreign equity markets, and small captoday.

The chart below right features the U.S. Dollar Index (DXY) futures along with the ratio between the World ex-USA Index and the Dow Jones IndustrialIndex.

The argument here is that from late 2001 into 2008 moneyhas been steadily moving away from the dollar in search of higher returns in non-U.S. equity markets. This trend has now run for roughly 7 1/2 years.

The point is that it has made perfect sense for years to sell dollars to buy non-U.S. equities but it would only take something like a good move above 75 on the U.S. Dollar Index to reverse the trend. Time and time again investors discover that it is much easier to get into a thin and rising market than it is to get out once the rush truly begins.



Equity/Bond Markets

The point we’ve made above is that the current trend continues to favor foreign equity markets and currencies at the expense of the dollar and large cap U.S. equities. A nice break above 75 by the DXY may be all that is required to reverse this trend and at that juncture one should be better off in dollars and large cap U.S. equities.

At right is a comparison between the stock priceof mining company Rio Tinto (RTP), the Brazilian i-shares (EWZ), and the Dow JonesLatin America Stock Index.

We have been running this chart daily for the past while in the back pages to show that the ongoing trend is getting a good test. In August of 2007 and again this page January all three markets declined to just below their respective 200-day e.m.a. lines before rallying on to new highs. The recent correction marks the third time that support has been tested and so far… prices have yet to snap back to the upside OR break to the down side. In other words we could be right on the very edge of a major trend shift that will favor the dollar and large cap non-commodity equitiesor… the markets may find some way to extend the trend through the summer and into the autumn.

Below we show a chart of Japan’s Mitsubishi UFJ (MTU) and a chart of heating oil futures.

The idea is that we are comparing the two-year down trend for MTU between the spring of 2006 and the spring of 2008 with the two-year commodity marketsdecline that stretched from the start of 1997 through into the beginning of 1999.

There has been a tendency over the past number of decades for one or more asset markets to push rather powerfully higher into the start of a new decade. It was commodity pricesinto 1980, the Nikkei into 1990, and the Nasdaqinto 2000. Typically the lift begins in earnest during the second half of the ‘8’ year which simply means that 2009 is going to be very positive for a number of sectors. If the trend is driven by weaker rather than stronger commodity prices then we very much like the prospects for Japan’s banking shares.