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


Tuesday, July 22, 2008

Chart Presentation: Assorted Thoughts

We have argued from time to time that when the S&P 500 Index trends lower through the first few weeks of a new quarter the pivot back to the upside is usually found somewhere around the 22nd to 25th day of the month. In other words with the equity markets weak to start the third quarter this year a more positive trend would be expected to show up some time this week. Given the reaction late yesterday to earnings from American Express, Apple, Merck, Schering Plough, Texas Instruments, and Sandisk it certainly appears that the equity markets will open the day under considerable pressure.

At right is a comparison between the S&P 500 Index (SPX) and the CRB Index with the charts shifted or offset by 18 months.

The argument is that through much of this decade the commodity markets have been leading the equity markets so, in a sense, recent strength in commodity prices should eventually prove to be a positive for equities. The twist is that the commodities and equities have been ‘taking turns’ with the last meaningful rally in the SPX taking place right after the turn lower for commodity prices in mid-2006.

For good or for bad this chart serves as one of our mental ‘road maps’ for the SPX. Our expectation was that the SPX would reach bottom in July and then work somewhat higher through into early 2009 before driving to the upside into the end of the decade. Given that there was a major asset price peak in 1980, 1990, and again in 2000 this broad concept seemed somewhat reasonable to us.

At bottom right we show heating oil futures and the ratio between Boston Scientific (BSX) and the SPX.

BSX reported earnings after the close yesterday and while the initial reaction seemed to be negative it paled in comparison to some of the 5% to 10% dives in other sectors.

The idea here is that in 2004 heating oil futures price broke to new highs and this marked the end of the road for stocks such as BSX. From 2004 into 2008 the trend for energy prices was ‘higher’ while BSX steadily declined relative to the broad U.S. market. The point, however, is that BSX has shown just enough relative strength over the past six months to build a tentative case that a rotation out of commodities and back to health care has begun. Of course much of this depends on how the markets react today to BSX’s earnings and forward guidance.

The chart below compares the stock price of Schering Plough (SGP) with the ratio between the S&P 500 Index and the DJ AIG Commodity Index.

SGP and Merck had a rough session yesterday as price declined following the delay of earnings until after the close then on disappointing results from a study on their jointly-marketed anti-cholesterol drug and then once again on the release of quarterly earnings.

The chart of SGP is almost identical to the ratio between equities and commodities so the argument would be that as long as the pharma sector remains negative commodities should outperform equities.

Below right we show the same comparison for a shorter period of time. As of last week SGP had rallied up to its 200-day e.m.a. line and into the declining resistance line formed by connecting the two peaks from late last year.

Below we show the pharma etf (PPH) and the combination of copper and crude oil futures prices (copper in cents plus crude oil in dollars and multiplied by three times).

The bad news is that were no positive earnings surprises from the pharma sector yesterday. The good news is that deep-pocketed European firms continue to make offers for dollar-depressed U.S. names. Following on the heels of InBev’s run at Anheuser Busch we had Roche taking a run at the balance of Genentech that it does not own yesterday. This helped push DNA and the biotech etf nice higher.

So... short-term, intermediate-term, and long-term the pharma sector tends to trend inversely to commodity prices. If the pharma group is going to show any kind of strength coming out of July we expect that it will have to come from continued weakness in both copper and crude oil futures prices. In particular we would like to see copper trading below 3.60 although it was on the rise yesterday ending around 3.69.

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 >>