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


Monday, August 11, 2008

Chart Presentation: Correction

Aug. 8 (Bloomberg) — Crude oil fell, heading for its fourth decline in five weeks, as the dollar gained the most in more than seven years against the euro, reducing the appeal of commodities as an inflation hedge.

Aug. 8 (Bloomberg) — Currencies across South America fell as a slide in prices of such commodities as soybeans, copper and oil erode the region’s export revenue.

Aug. 9 (Bloomberg) — U.S. stocks rose, sending the Standard & Poor’s 500 Index to the largest weekly rally since April, as retailers, automakers and restaurants climbed on speculation earnings will improve as oil retreats.

Our view is that the trend has now shifted away from rising commodity prices and is in the process of moving towards large cap U.S. and Japanese equities along with the dollar and, in due course, the yen.

We will argue, however, that the case for long-term commodity price growth might best be served by a short-term rout for raw materials prices through the balance of the summer and into this year’s fourth quarter.

The chart at top right shows the ratio between equities (S&P 500 Index) and long-term Treasuries (30-year T-Bond futures) from 1986 into 1988. The 1987 stock market ‘crash’ helped remove the speculative excesses from the equity markets by hammering the equity/bond ratio back 1986 levels. The point is that the 1987 stock market collapse did not precede a depression, recession, or even a serious growth slow down but instead helped bring relative prices back into line so that the overall trend- which favored equities over bonds- could proceed at a more orderly pace.

The chart below right features the ratio of commodities (CRB Index) to equities (S&P 500 Index) from 2007 to the present day. The argument would be that this ratio should decline back to somewhere close to .22:1 (i.e. the SPX 4 to 5 times the level of the CRB Index) through declining commodity prices and rising equities before starting the slow process of building back to the upside over the next two to three years.

Our view is that the markets are in the early stages of correcting the excesses built into the commodity markets and, if all goes well, this process could be largely completed by the cyclically weak October/November time frame.

At top right we have included a chart of Merrill Lynch (MER) from 1998 along with a chart of copper producer FreePort McMoRan (FCX) from 2008.

We are featuring this comparison in an attempt to show- in general terms- how we think the markets are going to resolve over the next few months. The idea is that FCX today is similar to MER in August of 1998.

MER’s stock price collapsed in 1998 during the Asian crisis that led to a sharp reduction in short-term U.S. interest rates which, in turn, helped to create the Nasdaq’s bubble into 2000. Our sense is that the markets are currently rolling from crisis to crisis in an attempt to pull short-term interest rates lower. The subprime fiasco lowered U.S. yields but with central banks concerned about inflationary pressures the next step is to hammer the commodity sector.

The markets tend to create offsets so the worse things got for the banks and brokers the faster the rise in commodity prices. Fair enough. The challenge now is to determine what the offset to falling commodity prices will be. Our focus over the past month or so has to been to determine what stocks or sectors are starting to lift as money moves away from the energy and basic materials themes. At bottom right we show a chart comparison between Intel (INTC) and FCX. Notice how INTC has been pushing higher since early July even as FCX has been trending lower. One of the potential offsets to commodity price weakness appears to be better strength in the tech and telecom sectors.

Below we show 3-month euribor futures and the ratio between Japan’s Mitsubishi UFJ (MTU) and the gold etf (GLD). From late 2005 into the summer of 2008 the trend favored gold over the banks (MTU) as European short-term debt prices declined. Our argument is that the new trend should lead to rising European debt prices and be more positive for the banks as commodity prices- including gold- decline.

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 >>