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- Kevin Klombies

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October 24, 2007

If you could predict how fluctuating Oil Prices would have impacted the market this week to nearly 80% accuracy, would you feel pretty confident about your trades? If you had a cost effective tool that would enable you to confidently forecast how Apple Computers surging sales and Wal Mart’s retail projections will play out in the market over the next four days, you could set your trades with confidence, right?

Go here and learn why thousands of customers in 90 countries have been raving about Vantage Point software -- their GPS for over 200 markets -- for nearly 30 years. See a demonstration of successful market forecasts made by this highly accurate and consistent tool.

While there are any number of ways to view the variety of trends and themes that dominate the capital markets there are perhaps two that stand out as offering the best explanation for what is going on. Either the markets are random in nature with prices rising and falling for no apparent reason or there is an underlying logic to the way markets adjust in price over time. Either past performance has nothing or almost everything to do with current and future outcomes. Either markets participants are wholly irrational as they fling darts in haphazard fashion or there is both a rhyme and a reason for why money moves from sector to sector, region to region, and theme to theme. Since we are not adherents of random walks, chaos theory, or unknowable outcomes we choose to believe that it is possible to discern at least certain facets of the future from the behavior of market and cycles in the past. For good or for bad that is our conviction.

There are a myriad of places to start and approaches to take when one sets out on an intermarket journey through the markets but for today we will begin with the chart below of the ratio between the stock price of copper producer Phelps Dodge (PD) and the S&P 500 Index (SPX).

If you cannot view the PD/SPX Chart, go here.

The PD/SPX ratio rises when stock prices within the commodity sector are stronger than the broad U.S. equity market and declines when the metals and mines are weaker than the overall market. The ratio made a significant top through 1981 followed by a multi-year decline and then a second top thirteen years later in 1994.

We are showing the PD/SPX ratio and not commodity prices per se for a reason. While the share prices of the commodity producers will most certainly rise and fall with the broader trend for commodity prices we are specifically interested in the equity market’s reaction to the trend. In other words our focus is not on commodity prices but on the swings within the equity markets over time in response to the trend for commodity prices.

The chart shows that after the long commodity bull market through the 1970’s the top for the commodity theme within the equity markets as shown through the ratio of the share price of Phelps Dodge to the S&P 500 Index occurred in 1981 and was then followed by a long period of relative weakness. The cycle reached a second peak thirteen years later in 1994 followed once again by a lengthy period of investor distain.

Our point is that over the past number of decades the markets have moved through broad cycles that have either favored or neglected the commodity theme and if one were to have applied this thesis to the markets back in the mid-1990’s the conclusion would have been to avoid commodities for at least the next five years and then shift back to commodity-sensitive positions to take advantage of the next cycle peak into 2007.

If you cannot view the FCX/SPX Chart, go here.

Whether the commodity theme peaks in 2007 and then turns lower for the next five years has yet to be determined but we can say with some certainty that no other peak has been reached at any time since 1994.

In the spring of 2007 FreePort McMoRan (FCX) bought out Phelps Dodge so to continue our journey we show a chart of the ratio between FCX and the SPX. The idea is that events were expected to converge in such a manner into 2007 that the equity markets would price those stocks involved with the production of commodities at peak levels. If the cycle were to repeat then for at least the next five years covering the first term of the next U.S. President the markets would shift relative strength away from the commodity sector either by bidding up prices in other markets or lowering the prices in the basic materials sectors. Or both.

Aside from that fact that thirteen years separates 1981 from 1994 what else was similar? In both instances after a rising trend for short-term U.S. interest rates yields began to decline around the end of the year.

The chart below shows 3-month Eurodollar futures prices. Similar to Treasury bills Eurodollars are priced at a discount to 100 so a price of, say, 96 reflects an interest rate on U.S. dollar deposits in non-U.S. banks of close to 4% while a price of 92 would suggest a yield of 8%. When 3-month Eurodollar futures prices are rising it means that short-term U.S. interest rates are declining and vice versa.

If you cannot view the 3-Month Euro Dollar chart, go here.

In both 1982 and 1995 Eurodollar futures prices began to rise. Put another way the peak for U.S. short –term interest rates was reached in both 1981 and 1994 concurrent with the extreme highs for the share prices of stocks involved in the production of basic materials. If our thesis has any merit then U.S. short-term interest rates would be expected to peak and turn lower coming out of 2007. So far, so good.

The commodity theme that favors metals prices and the stock prices of the miners can include or go with a variety of other themes including Asian growth and the commodity currencies (i.e. Canadian, Australian, and New Zealand dollars). On the flip side this can also go with weakness in the currencies of those countries that consumer commodities- notable Japan and the U.S. The Japanese Yen, for example, has bottomed against the Australian dollar (JPY/AUD cross rate) on two previous occasions- 1990 and 1997- that not coincidentally marked the highs for crude oil prices.

To really ‘see’ how the markets shift capital and focus back and forth over time we have included a chart of the ratio between JP Morgan Chase (JPM) and Phelps Dodge from the spring of 1980 into the spring of 2007. The chart makes the rather succinct case that for as much as the current market may seem to be unique and part of a trend that will last- as many apparently believe- for years or decade to come, it is more likely just a part of the readjustment of relative prices process.

If you cannot view the JPM/PD Chart, go here.

As the commodity theme tops out and turns negative this year those markets and sectors that have risen with commodities should weaken and those that have been declining as a result of or concurrent with commodity price strength should strengthen. The U.S. dollar should turn higher along with the Japanese Yen as currencies from the Brazilian real to the Canadian dollar turn lower.

Since the markets are dynamic in nature with new trends forming and emerging even as the old trend come to a close we would also expect to see early signs of new relative strength in rather unexpected areas. Unexpected, that is, if one does not come to terms with the idea that the markets are cyclical in nature with periods of excess ultimately leading to years of underperformance, capital starvation, and consolidation.

Our sense is that there are two areas in particular that should be watched for signs of a trend change- the Japanese Yen and the share prices of the U.S. large-cap consumer stocks.

To create and sustain a trend capital has to move rather consistently in a single direction as it shifts away from one sector or region towards another. One of the key features of the recent trend has been weakness in the Japanese Yen- most particularly against currencies like the Euro, Canadian dollar, and Australian dollar- but also against the U.S. dollar. Exchange rates tend to shift to reflect the direction of the flow of capital so the weaker Yen indicated that money was flowing out of Japan in search of higher returns.

If you cannot view the Japanese Yen Continuous Chart, go here.

The chart above shows that from mid-2007 to the present day the Japanese Yen has been rising against the U.S. dollar. In other words the flow of capital out of Japan into any and all foreign markets is starting to show signs of wear, tear, and age. Many have noted the similarity between the trend for the cross rate between the Euro and the Yen (Euro/Yen) with that of the U.S. equity markets concluding that the only way stock prices can rise is if the Yen continues to decline but that misses the point. It is true when the trend is dominated by growth opportunities outside of the U.S. and Japan but certainly not true if, as, or when the markets shift back to a predominantly non-commodity theme.

If you cannot view the KO/SPX Chart, go here.

The chart above shows the ratio between the share price of Coca Cola (KO) and the S&P 500 Index (SPX). The KO/SPX ratio rises when large cap U.S. consumer stocks outperform the broad market and declines when these stocks are weaker.

The KO/SPX ratio made a bottom through 1981 and then began to rise through the last stages of the peak in the commodity theme. It made a second bottom into 1994 before resolving higher as the PD/SPX ratio shown above was making its next top. Once again the ratio made a long base into 2007 and is on the rise.

The point is that themes tend to overlap so that the start of a rising trend for thoroughly non-commodity stocks like Coca Cola will begin during the last stages of the commodity theme. While investors are chasing the last scraps of the basic materials trend and levering up bets on the next potential take over target the trend changes and, if history and our experience is any guide, those who made the most money in the commodity trend will spend years giving it most or all of it back.

We will argue that if there is any validity to the notion that the commodity sector makes a relative strength every thirteen years then three things should happen in 2007. The cyclical strength that helped push commodity prices upwards should falter leading to declining interest rates. The flow of capital that drove the trend should shift leading to a reversal in the direction of exchange rate movements. Finally within the equity markets the sectors that have under performing should begin to strength.

A trend requires a constant and usually ever increasing flow of capital to validate and define its existence. To the extent that capital has to cross borders to follow the trend it will have an impact on exchange rates. When better returns are available in the commodities sectors then money will move away from the consumer, pharmaceutical, and financial sectors. When small cap is all the rage then large cap will be neglected. To understand the difference between a correction in the trend and an actual change in the trend one has to at least understand what the trend is and from our perspective the tentative signs of strength in the Yen and large cap consumer stocks such as Coca Cola argue that the next significant sell off in energy and metals prices- including, we suspect, the non-Japan Asian equity markets- will mark the end of the trend.

The end of the trend, however, is not the end of the world. The end of the trend that included the sale of gold (i.e. gold carry trade) to fund the purchase of other assets simply marked the low point for gold. The end of the trend that created the tech and telecom bubble into 2000 marked the start of a rising trend for real estate prices. The end of the trend that includes the sale of the Yen to fund the purchase of non-Japanese bonds and equities will most likely mark the start of rising Japanese interest rates and asset prices.

When the trend changes expect to see a rising Yen, relative strength in the large cap pharmaceutical and consumer stocks, and eventually a recovery in the U.S. financial sector. If history repeats expect that once the commodity trend turns negative it will remain that way on a relative basis for years to come.

Kevin Klombies is a prolific writer and market analyst. After graduating in 1980 from the University of Saskatchewan with a Bachelor of Commerce degree (Honours) in Finance/Economics, he was a broker for about 16 years for Wood Gundy Inc./CIBC Wood Gundy (changed name around 1990) Private Client Division.

While at Wood Gundy, he began to create the inter-market work that would later become the IMRA newsletter. He recalls starting with a DOS version of Metastock that he used to print out charts, drawing lines on them with a pen and ruler and taping them together upside down (at times).

The first market review that he put together was in 1988 and was based on annual percentage changes in U.S. M1 versus the equity markets. It ended up going from desk to desk right to the Bank of Canada, which said there was, in fact, no relationship between money supply growth and the equity markets (“which probably explains why I have so little respect for central banks,” he says).

Klombies says his broker career was uninspiring, mainly because he spent way too many hours running charts and too little time prospecting for business. He found that what he liked best was analyzing the markets and what he liked least was selling, marketing, and client service. So he eventually left the business and continued to work on the analysis while doing some trading and consulting.

He has been featured on a number of web sites, interviewed by Reuters TV in London and marketed by Agora Inc. (Daily Reckoning, etc.), but the majority of what he does is done privately and quietly.

If you could predict how fluctuating Oil Prices would have impacted the market this week to nearly 80% accuracy, would you feel pretty confident about your trades? If you had a cost effective tool that would enable you to confidently forecast how Apple Computers surging sales and Wal Mart’s retail projections will play out in the market over the next four days, you could set your trades with confidence, right?

Go here and learn why thousands of customers in 90 countries have been raving about Vantage Point software -- their GPS for over 200 markets -- for nearly 30 years. See a demonstration of successful market forecasts made by this highly accurate and consistent tool.