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


Thursday, July 10, 2008

Chart Presentation: 1987 Comparison

Chart-wise one can trace downward pressure on the financial sector back to the start of central bank interest rate increases in both Europe and Japan. Our view is that the trend for short-term European interest rates remains one of the keys for the markets through the balance of the year.

The markets remained locked within a circle of sorts. Rising commodity prices push European interest rates higher which in turn leads to a stronger euro and weaker dollar. On dollar weakness commodity prices rise which increases inflationary pressures and leads to even higher European interest rates which pushes the euro higher. Rinse and repeat.

There are any number of ways that this circle could ultimately be broken but perhaps the best and, we suspect, the most likely would come from a sharp decline in commodity prices. Why? Because if the European Central Bank was to cut interest rates in the absence of commodity price weakness- similar to the Fed’s actions last year- it is possible that commodity prices could accelerate once more to the upside. Ideally commodity prices break first followed in due course by the ECB which would lead to weakness in the euro and a second round of downward pressure on raw materials prices.

We have been focusing on the way the ratio of commodity to equity prices into 2008 resembles the ratio between equity and bond prices through 1987 in recent days so at right we show the denominator from both ratios. The chart at top right features the U.S. 30-year T-Bond futures from 1987 while the chart below right includes the stock prices of Merrill Lynch (MER) and Lehman (LEH) from 2008.

In 1987 the TBonds broke to new lows at the end of August and then continued to decline relentlessly right up to the point where the stock markets ‘crashed’ on October 19th. In 2008 the stock prices of MER and LEH broke to new lows at the end of May and have entered the new quarter choppy but lower. In other words our sense is that if our argument is going to work we will see pressure building on the financials until something literally explodes. In 1987 the bond market recovered as equity prices collapsed while in 2008 it may take a very concentrated spate of weakness in the commodity markets to relieve the selling pressure on the banks and brokers.

Below is a comparison that we have shown in these pages on quite a few occasions. It starts at the bottom with airline AMR and then shows refiner Valero (VLO), gold miner Barrick (ABX), natural gas producer Duvernay (DDV on Toronto), and finally the biotech etf (BBH).

The biotechs turned lower at the end of 2005 so it makes some sense to think that they will eventually turn positive ahead of those sectors that peaked a year or two later. The argument is that when AMR peaked the markets changed themes and pumped the share price of VLO upwards. As VLO peaked the trend shifted to the golds as ABX rallied and then as the gold sector peaked the trend shifted over to sectors such as coal and natural gas which led to a rally in DDV from around 28 up to 67.

When the natural gas/coal/energy theme peaks- and it appears that it did so around the end of the last quarter- the equity markets are ‘supposed’ to move on to something new. We have suggested on occasion that it is very difficult to ‘see’ what the new trend is until after the bulk of the quarterly earnings are released so things will become a bit more clear as we move into August. However one early candidate has to be the biotech sector given the recent strength in the BBH.

Below we show copper futures and the price spread or difference between the 30-year and 10-year Treasury futures. Yesterday the 30-years closed at 117 6/32 while the 10-years ended at 115 16/32 resulting in a spread of 1 22/32.

In general the spread rises with falling copper prices and declines with stronger copper prices. In general bond prices rise when the spread widens and also in general bond prices rise when copper price are weaker.

The last two bottoms for copper- in early and late 2007- went with the spread widening out to +5. If copper prices break lower later this month the next potential bottom of any significance could be found around the time that the 30-10 price spread widens out to around 5 points.

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 >>