by Kevin Klombies, Senior Analyst

Wednesday, October 24, 2007

Chart Presentation: Triples

It is Wednesday once again and Wednesday means the release of the weekly U.S. energy inventory numbers. Time and time again crude oil prices have declined early in the week and then rallied sharply higher towards the end of the week. Often we have seen sharp down days for energy prices on Tuesday and even sharper up days on Thursday. Our view, however, is that commodity prices are making a double top similar to last year with the two peaks set almost exactly three months apart. If so then crude oil prices are in the process of turning lower. Whether this means yet another rally back towards 90 and then lower prices or a non-stop melt down towards 76 is open to question. Time will tell.

We thought we would shift gears somewhat and show a relationship that has intrigued us this year. It starts with the Chinese equity market but has potential ramifications for other markets as well.

The chart below is of China Southern Airlines (ZNH). We have argued in the past that the chart of ZNH was almost identical (for several years) to that of Canada’s WestJet (WJA on Toronto). Their paths diverged in May when ZNH exploded up through 30 on the way to 100.

How in the world did an airline stock more than triple in price in the face of such intense energy markets strength? The answer, we suspect, lies with the chart below right of the Shanghai SE Composite Index.

In early 2004 energy prices began to drive to the upside which in turn helped push U.S. short-term interest rates up from the 1% level. In many ways this was the point in time when the markets ‘split’ into camps of winners and losers. We have argued on many occasions over the past year or so that those stocks and markets that were forced lower after the spring of 2004 were now on the rise and that was most certainly the case with the Shanghai Comp.

The Chinese equity market topped around 1800 in the spring of 2004 and then declined by close to 45% into 2005. In October of last year this index finally broke above the 2004 highs and then proceeded to rise by more than 300%.

ZNH lagged behind for months but when it eventually broke above 30 it played ‘catch up’ with the trend by compressing the entire price tripling into a few short months. The reason ZNH was able to triple was because the broad Chinese equity market was in the process of tripling. With that in mind we proceed to the next page.



Equity/Bond Markets

Below we show WestJet (WJA) and the Canadian equity market (S&P/TSX Composite Index (TSX)).

Similar to ZNH, the stock price of WJA has been holding below the 2004 peak . Our view has been that it should eventually resolve back to the 20- 21 level but when we pondered the break out by ZNH we wondered whether this was going to mark the end of the start of the rally.

The TSX has risen by roughly 60% since 2004 with a majority of these gains coming from strength in the commodity sector. WJA is now benefiting from the strong Canadian dollar as Canadians, like geese, line up to fly south for the winter and to take advantage of much lower U.S. retail prices. The only thing missing is the psychological boost that would come from falling energy prices.

The third chart below compares the pharma etf (PPH) with the ratio between the SPX and the DJ AIG Commodity Index. The equity/commodity index tends to rise once commodity prices have peaked and interest rates begin to decline.

The short-term argument is that the ratio is stuck within a range between 8.4 and 9.1. At the bottoms the PPH tends to rise. A break beyond 9.1 would be equity markets positive while a clean break below 8.4 would suggest that commodity prices are going to continue to rise.

Below we show U.S. 2-year T-Note futures and the ratio between crude oil and gasoline futures.

The crude oil/gasoline ratio is hammered right into the top of the long-term trading range so all things being equal we are unlikely to see major strength in crude oil without even greater strength in gasoline futures prices. All of which simply means that today’s inventory report is important. If, for example, gasoline futures were to decline to 2.00 from 2.10 and the ratio dipped from .41 to .38 crude oil priced would be at 76.