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


Wednesday, August 6, 2008

Chart Presentation: Relative Prices

As expected the Fed held the funds rate flat at 2.0%. At present the markets expect that the funds rate will drift a bit higher before year end with roughly 60% odds that it will be at 2.25% or 2.50% by mid-December.

We return to the same two charts that we showed yesterday. The only difference today is that we are including a chart of the U.S. Dollar Index (DXY) futures below.

The argument is that the trend for commodity prices got as over done relative to equities this year as the equity market did compared to the bond market in 1987. Our view is that the stock market’s ‘crash’ in October of 1987 was, in general, a rebalancing of relative prices and we support this argument by noting that there was a notable absence of a depression or even a recession following the stock market’s collapse.

In any event after the usual and somewhat shameful ‘end of quarter ramp’ for commodity prices relative to equity prices the trend reversed rather suddenly in July to the chagrin, we imagine, of the ‘this time is different’ commodity bulls. In fact the correction to date has been fairly mild as the CRB Index has only pulled back to just below its 200-day e.m.a. line.

Our thought today is... for as bad as this has felt to date for those long commodities and commodity-related equities... how much worse might it get if the U.S. dollar actually breaks out of its down trend? The DXY futures would have to get nicely above 75 to turn the trend compared to yesterday’s intraday high of 74.335.

We are going to stick with the chart at right for one more day. The chart shows the ratio between the S&P 500 Index (SPX) and crude oil futures.

We commented yesterday that on many occasions over the past couple of years crude oil futures prices ramped higher at the exact moment that the SPX futures turned lower. The relationship was so tight that it felt as if the ‘buy crude oil and sell U.S. equities’ had become one giant ‘pair trade’.

The chart shows that from January of 2007 through into June of this year the SPX/crude oil ratio rallied and then failed on numerous occasions. Our thought is that if, as, or when this trend breaks it should do so in a manner significantly more dramatic than what we have seen so far. By this we mean that the ratio shouldn’t snug up to 11:1 and then flatten out but should bust to 13:1, 14:1, or 15:1 and then continue to rise until the last speculative position has been forced out. Of course... it is also likely that we are ‘talking our book’ here.

Crude oil futures have obviously been weaker on an absolute basis but we are still looking for relative price weakness compared to commodity prices in general.

At bottom right we show General Motors (GM) and the ratio between the CRB Index and crude oil futures. The chart makes the rather compelling case that it is NOT a good idea to own the autos as long as the CRB Index/crude oil ratio is trending lower. The chart also suggests that the only real over head resistance level for the CRB/crude oil ratio is somewhere around 9:1. Given that the CRB Index includes energy prices and was last seen at 398... the argument is that crude oil prices could decline far lower than most expect possible.

The CRB Index/crude oil ratio works nicely for some of the airlines as well. The chart below shows this ratio along with JetBlue (JBLU). Once again... our interest in the autos and airlines will increase substantially once crude oil prices begin to weaken both on an absolute and a relative basis.

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 >>