by Kevin Klombies, Senior Analyst

Tuesday, August 15, 2007

Chart Presentation: Trends

The rest of the world knows that the toxic waste batched, bundled, securitized, and marketed as investment grade paper is the reason the financial markets are coming apart at the seams. Our view, however, is that the subprime melt down is merely a function of a trend that went too far for much too long. The trend included strong commodity prices, a weak dollar and yen, and significant outperformance by both small cap U.S. shares and foreign equity markets.

We have argued in the past that lower volatility tends to go with strong metals prices so the rapid increase in volatility marked the top for the metals markets. A similar argument can be made for subprime mortgages. People simply do not default en masse on real estate in a rising price market so the cracks do not begin to appear until prices start to decline. From Zimbabwe to Iceland all smaller markets and currencies appear to offer nothing but upside in a strong commodity trend but once the trend stops rising investors find that it is often much harder to get out than it was to get in.

The chart compares crude oil futures, the stock prices of Bear Stearns (BSC), and that of Microsoft (MSFT).

In a sense everything was progressing quite nicely through the second half of 2006 as commodity prices moved lower along with interest rates while the non-commodity sectors pushed higher. As crude oil futures declined from the hurricane-prone month of August into January of this year the trends for large cap names like Microsoft, Intel, and Cisco was positive.

The problem is that in January the trend switched back to strong energy prices. Without any significant change in the global fundamentals surrounding the supply and demand for crude oil the price moved from the highs 70’s down to 50 and then back to the highs 70’s. We suspect that the only difference at these extremes was the size of the speculative long and short positions in the oil futures market.

As crude oil prices moved higher this year the markets were forced to unwind expectations of easier credit conditions. With the Fed diligently worrying about inflationary pressures one commodity after another took a turn spiking higher. While definitely more dramatic the situation today is similar to that of last week, last month, and last quarter. As crude oil prices trend higher there is downward pressure on the non-commodity equity markets sectors and that will only change when oil prices start to decline in earnest.


Equity/Bond Markets

The chart compares the stock price of Johnson and Johnson (JNJ) with the Amex Oil Index (XOI).

JNJ tends to trend inversely to the oils so when crude oil is strong and rising in price it puts downward pressure on JNJ. The problem recently has been that XOI has enough room within its rising channel to fall from above 1500 to roughly 1300 without changing the trend. The equity markets would do better with stronger oils or with weaker oils but with the trend stuck in neutral both the oils and non-oils remain weaker. In other words there is still too much strength in crude oil prices to lift the sectors that have been negative since January and not enough strength in crude oil to keep the major oil stocks pushing upwards.

Another view is shown below using Genentech (DNA) and copper miner FreePort McMoRan (FCX).

The miners have been somewhat weaker of late as FCX has dipped from around 100 down to below 85 but the share price is still in a positive trend which serves to hold biotechs like DNA lower. DNA tends to rise with the dollar while FCX tends to rise with a weaker dollar so in trading yesterday DNA closed higher while FCX was lower as the U.S. dollar moved up through 81.

One of our arguments of late has been that from 2000 into 2007 the major trend included dramatic outperformance by smaller cap stocks and equally dramatic outperformance by foreign equity markets.

The chart below shows the Canadian equity market (S&P/TSX Comp.) and the ratio between the S&P 500 Index and NYSE Composite Index.

The chart makes the simple case that for as negative as the SPX has felt recently it is actually showing relative strength. The Canadian equity market has fallen sharply back to its rising 200-day e.m.a. line while the ratio has risen up to its moving average line. Our view remains that we like the dollar and we prefer large cap U.S. names.