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


Thursday, August 7, 2008

Chart Presentation: Trend Test

Let’s cut to the heart of the matter. Our view is that the U.S. dollar is going higher. The markets, on other hand, were trading yesterday as if the dollar was going to stall at or near the 200-day e.m.a. line which would, in turn, swing commodity prices back to the upside.

The chart at top right compares the U.S. Dollar Index (DXY) futures with the CRB Index. The simple point here is that the CRB Index has declined to its moving average line as the DXY has moved up to its moving average line. If the dollar resolves lower- as so many expect- then a good case can be made for a stronger commodities market.

In general there are likely only three potential outcomes here. The dollar can continue to rise moving up through the moving average line, it can return to the ‘flat’ trend that began this past March and hold below the moving average line, or it can tank to new lows. In other words two outcomes out of three favor the commodity markets.

The chart below right compares copper futures with the ratio between the stock prices of Caterpillar (CAT) and Pepsi (PEP).

We use the CAT/PEP ratio as a way to determine the direction for the broader ‘commodity cyclical’ trend. The ratio trended higher through the first half of the year on rising copper prices before peaking in mid-June.

From the start of the third quarter through yesterday the general trend has been negative for copper prices which has led to a declining CAT/PEP ratio. We could show any number of charts ranging from the ratio of the Canadian to the U.S. equity markets, Brazil to the U.S., FreePort McMoRan relative to Johnson and Johnson, or even simple charts of stock such as Potash and Rio Tinto and the basic message would be the same: the markets traded yesterday as if the correction in commodity prices had come to an end.

Our point today is that this is entirely possible IF the dollar is going to turn lower once again. In a sense the action through the last five weeks has been the ‘easy part’ as the dollar pushed up to resistance while the CRB Index fell to support. For as much as we would like to argue that a major trend change has already begun- and we actually believe that to be the case- it is hard to do so with real conviction given the current positions of the CRB Index and DXY. Our view is that the dollar is going higher but ultimately the markets are the final arbiter.

At right we show a chart comparison between Potash Corp. (POT) and the sum of corn futures and soybean futures.

We have been showing this chart in one form or another almost daily for weeks now. The argument is that ‘ag’ stocks such as POT are trending with grains prices which, we admit, makes more intuitive sense than many of our comparisons.

At times we have focused on the actual numbers from this chart as we suggest that ‘fair value’ for POT may be something close to the sum of corn and beans. In other words when corn plus beans reached 24.00 at the start of July this ‘went’ with a price of 240 for POT.

In any event our focus today is on the position of ‘price’ relative to the 200-day e.m.a. line (red line on chart). Notice that POT touched the moving average line on Tuesday and then bounced nicely yesterday. Notice then that the sum of corn and soybeans broke right through the moving average line and made new lows yesterday. To the extent that this comparison is and has been ‘working’ the divergence yesterday suggested rather strongly to us that the equity markets were attempting to anticipate the inevitable bounce in commodity prices that would come from renewed dollar weakness. We shall see. More on the dollar on page 3 today.

Below is one of our favorite charts. Typically any chart that we like will be more than passing strange and we imagine that this one is no exception.

The chart shows the ratio between Exxon Mobil (XOM) and Boston Scientific (BSX). On the chart we have added a number of colorful horizontal lines. Each line not only represents a duration of time but also represents the SAME duration of time. In other words the amount of time between the peak for the ratio in 1993 and the peak at the end of 2000 is almost identical to the time between the 2000 peak and the top at the start of 2008. The same is true between the bottom for the ratio in early 1997 and the bottom in the spring of 2004. The point? To the extent that the ratio describes alternating trends that favor ‘energy’ and then ‘health care’ and to the extent that history is kind enough to repeat... one would be much better off shifting to health care and holding that position all the way into the first half of 2011.

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 >>