by Kevin Klombies, Senior Analyst, TraderPlanet.com

To understand what something is at times it makes sense to at least rule out what it is not. In other words after sharp gains of close to 7% yesterday in both the energy and basic materials sectors we are going to argue that this is not a return to the glory days of the bullish commodity trend.

To get from here to there we are going to use the ratio of Coca Cola (KO) to the S&P 500 Index (SPX). Our ongoing argument has been that the point in time when the KO/SPX ratio bottoms and turns higher marks the ‘intermarket peak’ for commodity prices. We use the term ‘intermarket peak’ because, quite clearly, this does not always line up with the actual top for the commodity markets.

In any event… the chart at top right shows crude oil futures, the CRB Index, and the KO/SPX ratio from the end of the first quarter in 1983 through 1986.

The KO/SPX ratio bottomed and turned higher in mid-1983 marking the ‘intermarket peak’ for the CRB Index. While commodity prices in general did trend lower through into 1986 crude oil prices held near the highs for close to 2 1/2 years before finally collapsing back ‘on trend’ through the end of 1985 and into the spring of 1986.

The point is that perhaps the largest decline in energy prices in recent memory (from above 30 to less than 10 in a matter of months) was preceded by a rising trend in the KO/SPX ratio.

The chart below shows the same comparison from the end of the third quarter in 2005 to the present day.

The chart shows that the KO/SPX ratio bottomed and turned higher in the spring of 2006 marking the ‘intermarket peak’ for commodity prices. The problem from our point of view was that after an initial decline through the end of 2006 the commodity markets ballooned higher for the next six quarters only to set an ‘actual peak’ around the middle of this year.

Our view is that the dramatic decline in the commodity markets was simply an example of a market coming back ‘on trend’ and try as we might it still appears as if crude oil futures prices are going to have to move down to or below 50 before the correction has run its course. The point is that the commodity markets are going to rally from time to time but to us this still looks more like a rally in a bear market than the start of a new bull trend or even a continuation of the old trend.

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Equity/Bond Markets

In recent issues we have shown comparisons of the current market with that of 1987. The argument has been that the first stocks back through their 200-day moving average lines represent sectors of relative strength while the first stocks to make new highs most definitely reflect the underlying trend.

We have shown that the stock price of nickel producer Inco cracked in 1987 with the broad equity market and then pushed on to new highs into the spring of 1988. Today we are going to take another swing at the argument but are going to approach it from a different perspective.

Second chart below shows a chart of Caterpillar (CAT), the Baltic Freight (Dry) Index, and the ratio between Caterpillar and Coca Cola (KO) from October of 1986 through September of 1988.

Circling the point somewhat… the stock price of Inco made new highs in the spring of 1988 which helped confirm that post-crash the trend was still dominated by rising commodity prices. The stock price of CAT did not make new highs but it tends to follow the same trend as the major mining companies.

Notice that the CAT/KO ratio turned higher in early 1987 (coinciding with the peak for long-term Treasury prices and the start of rising yields). The ratio broke sharply lower during the stock market ‘crash’ and then quickly returned to a rising trend.

The point is that the 1987 stock market ‘crash’ occurred within the back drop of a very strong cyclical trend that included rising ocean freight rates. The Baltic Freight Index rose before the crash and continued to rise after the crash in a similar manner to the CAT/KO ratio.

Where are we going with all of this? To explain we show the same comparison at bottom right from the current time period.

What is different between 2008 and 1987? Quite a number of things actually. Bond prices, for instance, were declining into the autumn of 1987 and were rising into the autumn of 2008. Ocean freight rates were rising through 1987 and have been collapsing through 2008.

The CAT/KO ratio was, as mentioned, rising during 1987 and has been moving lower with the Baltic Freight Index for much of the second half of 2008.

Now… we have argued that 2008 has been a classic example of the ‘sell in May and go away’ adage. We have also made the point that cyclical declines that drive into the month of October tend to make a momentum bottom around the 10th of the month and then pivot higher around the final week of the month. So far… that has been about right.

It could be that the October lows marked the end of the cyclical correction and the start of a recovery that will power on through into next spring. Our point today is that from a number of perspectives the recent stock market debacle had a similar ‘feel’ to 1987 even though the drivers were obviously quite different. In 1987 the stock market’s decline served to reset relative prices but once the dust had settled the commodity trend continued unabated. In 2008- we have argued- the stock market’s collapse served to reset relative prices but instead of a rising commodity trend we are faced with a negative commodity trend. Instead of a rising CAT/KO ratio our expectation was that the ratio should continue to decline.

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