by Kevin Klombies, Senior Analyst TraderPlanet.com

Monday, July 21, 2008

Chart Presentation: What If

Today’s topic is something of a ‘what if’. By this we mean that the markets are currently set up for one of two very different outcomes so the theme is ‘what if’ the one we are expecting to transpire actually occurs.

Below we show a chart of crude oil futuresfrom March of 2006 through June of 2007. The focus here is on the decline for crude oil prices through the second half of 2006 followed by a sharp trend reversal back to upside in January of 2007.

Below we have included a chart of Coca Cola (KO) from September of 2007 through to the present day.

The premise is that Coke today may be similar to crude oil futuresprices in January of 2007.

Coke reported disappointing earnings last week which helped sell the stock pricedown to the 50 level. In terms of our ‘what if’ argument the point would be that the markets sold the stock lower through the entire second quarter so to some extent the negative news was anticipated and already discounted.

Over the past few years the equity markets have shown a tendency to change themes every six months with the ‘driver’ for the trend change coming from shifts in the commodity marketstrend. It seems likely that a better trend for Coke would come from a continuation of weakness in commodity prices.

When we have viewed past trend changes related to the commodity markets we have seen that most of the pivots have tended to occur late in the first month of a new quarter. In other words crude oil prices drove lower through the first half of January back in 2007 and then turned sharply higher so the recent weakness in KO’s share priceis actually ‘somewhat’ consistent with a bullish outcome.

From an intermarket perspective the two outcomes that appear most likely are a return to rising commodity prices leading to copper futures moving on to new highs as Asian growth expands or a switch over to large cap consumer names such as Coke, Pepsi, and Proctor and Gamble in response to weakness in raw materials prices and Asian growth. Given the similarity between Coke’s chart and that of crude oil in January of 2007 our argument would be that we should have a clearer sense of which outcome is more likely as we push through the remainder of the month.

klombies_072108_1.jpg

klombies_072108_2.jpg

Equity/Bond Markets

Below we show a comparative view of copper futures and the stock price of Coca Cola (KO).

The page 1 argument was that sharp sell off in Coke’s share price this month reflected the markets discounting and then re-discounting last quarter’s negative fundamentals. Now that the news is out it is time for the markets to shift focus from the past back to the future.

The negative trend for KO through the first half of the year is a reflection of the positive trend for copper prices. In other words since Coke and copper tend to trend in opposite directions if copper futures were to break below the rising trend line we could make a fairly reasoned case for better share price action for KO.

If we put this all together it goes something like this. KO has been trending lower for the past six months as copper prices have trended higher. KO’s chart, however, is so similar to crude oil futures through the second half of 2006 that it is possible that the break lower this month is merely a set up for a pivot back to the upside but for that to occur we would need to see continued weakness in commodity prices and- at minimum- a decline by copper futures prices through support in the 3.65 range followed by an eventual break of 3.50.

Below we show the euro futures and the spread or price difference between 3-month euribor futures and 3-month eurodollar futures.

To save time and effort we are simply going to refer to the euribor minus eurodollar chart at ‘the spread’.

When the spread is above the ‘0’ line it means that U.S. short-term yields are higher than similar European yields and when the spread is below the ‘0’ line the opposite would be true. When the spread is at 2.0 it means that U.S. 3-month yields are 2% higher than European yields.

The charts have been shifted or offset by one year so that the euro in, say, 2000 is lined up with the spread in 2001.

This particular argument says nothing about the future direction of the euro and is instead focused on what the trend for the euro ‘says’ about the future direction of the difference between U.S. and European short-term interest rates.

Most believe that if European interest rates are ‘high’ relative to U.S. interest rates then the euro should rise against the dollar. This view approaches the argument from the opposite perspective by arguing that if the euro is strong and rising then over the next twelve months U.S. short-term interest rates should rise relative to European interest rates.

The point is that the subprime mortgage crisis created a temporary distortion within the markets and led to an extension of the rising trend for the euro. Over the next 12 months we would expect to see the spread swing sharply back above the ‘0’ line as U.S. yields rise dramatically relative to European yields. If the euro is at a cycle peak this summer then by mid-2009 we would expect to see the spread reach its next peak before turning lower once again into 2010.

klombies_072108_3.jpg

klombies_072108_4.jpg

klombies_072108_5.jpg