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


Friday, July 18, 2008

Chart Presentation: Rotation

We very much like animals so we hesitate to return to one of our oft-repeated topics in a manner reminiscent of beating a dead horse but to the extent that this seems timely... we are going to do so anyway. Our apologies to our equine readership.

The premise is that the markets have shown a tendency to make dramatic trend changes in the first month of a new quarter. Many of the key energy-related trend changes have occurred in January and July so this is the time and the place to start looking of something new. We have argued that the first half of 2006 featured a positive energy trend while the second half focused more on the non-energy sectors as commodity prices declined. The first half of 2007 was dominated by rising energy prices with an emphasis on gasoline prices while the second half was dedicated more to the collapse of the financials with offsetting strength in the gold miners. The first half of 2008 showed a return to the energy theme with much of the strength showing up in the natural gas and coals stocks and as we push into late July we see indications of weakness in both crude oil and natural gas prices.

The chart at right starts at the bottom with AMR which pushed higher through the second half of 2006. From there the markets changed themes and ramped the share price of refiner Valero through the first half of 2007 before moving on to Barrick during the second half of the year.

As Barrick reached a peak the theme shifted once again so we have used Canadian natural gas producer Duvernay to represent the broader ‘natural gas and coal’ sectors. Royal Dutch Shell bid for Duvernay last week in what we suspect will prove to be one of the worst timed buy outs in modern history. Time will tell, of course.

If the markets are ready to shift gears then whatever gains momentum coming out of July should hold through into the end of the year. Our mission of late has been to try to identify those sectors that are showing relative strength as the energy theme turns negative. The obvious choice this week would be the financials although we will feel somewhat better about this once we see the reaction to Citigroup’s and Merrill Lynch’s numbers today. A second broad theme would be health care. We have included a number of charts on the back pages but note that names such as Medtronic (MDT) and St. Jude Medical (STJ) showed indications of ‘gapping’ higher this week.

Today’s theme might well be a return to past arguments. A word of caution is probably also in order.

For those who recall... we argued for months (likely years) that we were positive on the commodity cyclicals. Day after day we featured arguments in favor of the major base metals producers even as copper prices floundered along close to 60 cents. We argued in favor of the gold miners back when gold was being sold below 300 by the Bank of England. It is our tendency even if we wish it were otherwise to be early and at times we can be a long ways ahead of the markets.

We tend to focus more on trend changes than the trend itself. Once the trend change takes place we will run with it for awhile and then move on to a new topic. Why? Partly because we believe that the markets move in cycles and partly because we get bored with making the same arguments day after day after day. The urge to find something new and interesting early in a new trend would have to represent a mea maxima culpa.

The two themes that we have hammered away on forever have been a stronger U.S. dollar and weaker crude oil prices. Now that oil prices are showing indications of weakness we would expect to see the dollar show better strength.

At top right we show our comparison between Carnival Cruise Lines (CCL), Wells Fargo (WFC), and the ratio between the Amex Oil Index (XOI) and the S&P 500 Index (SPX).

The premise has been that when CCL and WFC are ready to break up through their 200-day e.m.a. lines the XOI/SPX ratio should be set to break below its moving average line. One explanation for the sheer size of the gains this week for WFC would be that it was a long way below its moving average line even as oil prices started to crack.

Below right we show the ratio between the CRB Index and the S&P 500 Index.

The argument that we made recently involved the comparison between this ratio and the ratio between equities and bonds back in 1987. The idea was that commodities as a broad asset class were as high relative to the S&P 500 Index as the SPX was relative to bond prices into October of 1987.

We argued that once the second quarter came to an end the CRB/SPX ratio should correct lower and that if it gained enough momentum it might actually turn into a 1987-style ‘crash’ for the commodities markets.

A hard ‘snap’ lower for the CRB/SPX ratio back to roughly the .22:1 level (equivalent to the CRB Index down to around 310 with the SPX rising back towards 1400) became a bit more difficult following the reaction to the earnings of Google, Microsoft, and Merrill Lynch after the close yesterday.

Our thought is that if the commodity markets are going to dig in and rally then they should do so today but if the S&P 500 Index futures push above yesterday’s high around 1263 (last seen in late trading closer to 1245) then we could see another day of downward pressure on the broad commodities markets.

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 >>