by Kevin Klombies, Senior Analyst, TradingEducation.com, LLC


Friday, June 13, 2008

Chart Presentation: Trend Shift

We are not, as a general rule, inclined to superstition but we have to admit that each and every time we start to write an issue for a Friday the 13th we feel somewhat uneasy. Fridays are strange markets day at the best of times.

In yesterday’s issue we started on the topic of consumer versus cyclical. The idea was that from time to time- recently this has meant about once per year- the equity markets shift from one theme to another. In other words following a period of relative outperformance by the cyclicals the markets work into a transition that begins to favor the more defensive consumer sectors.

The argument was that this kind of trend change shows up in a reversal for the ratio between Pepsi and Caterpillar or, as we show below, the ratio between the Morgan Stanley Consumer Index divided by the Morgan Stanley Cyclical Index.

Below we show this ratio along with the U.S. 10-year T-Note futures and the CRB Index from 2006 while below right we show the ratio, the T-Notes, and the Bank Index (BKX) from 2007.

In 2006 the consumer/cyclical ratio bottomed as copper prices and the CRB Index reached a peak. The bond market declined in price through into June and then turned upwards.

In 2007 the ratio pivoted upwards in July as bond prices rose.

One of the points that we made yesterday was that pivots from cyclical to consumer go with rising bond prices and falling yields but for that to happen, we suspect, one or more major sectors has to break lower. Bond prices pushed higher in 2006 on weak commodity prices and then pushed higher in 2007 as the banks moved into crisis.

The charts suggest that real commodity weakness did not begin until about 3 months after the ratio pivoted while the BKX did not move into a free fall until close to 3 months after the ratio’s bottom in 2007. All of which suggests that we might not find out until August whether the inevitable pressures will be focused squarely on the commodity or the equity markets.

We have included three comparative charts on this page. Each comparison is based on the S&P 500 Index (SPX), the ratio between Caterpillar (CAT) and Pepsi (PEP), and the stock price of Caterpillar. The chart at top right is from 2006, the chart at bottom right is from 2007, while the chart below is from 2008.

The argument made yesterday was that when the markets changed trend in 2006 and 2007 so that the cyclical stocks (CAT) began to underperform the consumers (PEP) the S&P 500 Index went into a reasonably short-lived tail spin. The decline in the SPX over the past month is wholly consistent with past tendencies.

We also argued that the lows for the SPX in both 2006 and 2007 were made once CAT’s stock price reached its 200-day e.m.a. line. Since CAT is somewhat ‘specific’ we have introduced a broader alternative on page 5.

We have a tendency to throw an awful lot of ‘stuff’ at the wall but we generally come back time and again to anything that we think is timely, relevant, or has even the slightest chance of being of value. This is the reason that we are focusing on the small details of this chart comparison.

The argument would be that the SPX is in the midst of a correction that will not end until the cyclical sectors have found first support while the consumer sectors start to show better strength. It is always possible that the equity markets will shift- hard- back into the cyclicals with the CAT/PEP ratio breaking to new highs but until that happens our view is that the next low for the broad market should be expected around the time that CAT returns to its 200-day e.m.a. line.

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Kevin Klombies is a prolific writer and market analyst specializing in the commodity stock market and bond commodity market trading in the energy sector. He  graduated in 1980 from the University of Saskatchewan with a Bachelor of Commerce degree (Honours) in Finance/Economics.  Click here for full bio >>