The Futures / Inter Market Report

Trading the World’s Markets                            

July 13, 2007

                                            
Matthew Caruso, CMT                                  
If you have any questions send them to:                
e-mail: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it This e-mail address is being protected from spam bots, you need JavaScript enabled to view it     

A continuation of the commodity driven bull market

                A few weeks ago on May 11^th we looked at the bull market in stocks in relation to the bull market in commodities, http://tradesystemguru.com/content/view/47/58. In previous market cycles the strength in the commodity sector has led to a fall in stocks. This relationship has been fairly consistent. Price spike in gold and crude oil in 1980, 1987, 1990, and 2000 have all coincided with market tops. The reason for this is that a large increase in the prices of commodities is inflationary. The reaction by the Federal Reserve is raising interest rates to help keep prices stable and to cool of the commodity price increases.

            This bull market that started in 2002 has been very different; this bull market is being pushed higher by commodities. The phrase “commodity driven bull market” has been used quite often and many people may wonder, “ How do we know that stocks are being driven by commodities?” The only source for that answer is market themselves. Figure 1 is the same chart from May 11^th only updated up to the current date. As mentioned in the May 11^th report, gold is a good proxy for metal commodities and the Canadian dollar is a good proxy for energy and metal commodities. The last time gold and the Canadian dollar corrected in February of this year, so did the stock market. When writing the May 11^th report gold was in the process of breaking its uptrend line. The result was a correction in gold until the end of June. The Canadian dollar climbed ever higher and stayed in its uptrend.

            It is interesting to note that the correction in gold led to a consolidation in the S&P 500. Perhaps it was the strength in the energy sector which is represented in the price of the Canadian dollar that prevented the S&P 500 from falling and kept it in a sideways channel. Once gold prices ended their correction and broke above their recent downtrend line, the S&P 500 soon after erupted to new highs. Last week’s report presented the probability of higher gold prices, and thus far gold has been climbing. That report was indirectly bullish for the S&P 500 as well, and stock markets did resume making records once gold broke out.

Figure 1 Chart by Metastock.com

There is one problem with the idea of a commodity driven bull market. Prices cannot possibly keep climbing at the rate they’ve been climbing at for the past few years otherwise inflation will eventually become way too high above the target inflation rate for most countries. As things currently are, central bankers are still on the defensive against inflation and higher commodity prices will only make that worse.  It seems that the difference in this bull market in commodities is that it is demand drive by newly developing nations need for resources. Therefore unlike the oil spike in the 1970s which was a supply shock leading to higher prices and lower growth, the current situation has high commodities prices as a result of growth which has thus far kept the world economy growing in the face of inflation.

The next link in the intermarket chain is the effect of interest rates on the stock market. Despite most commodities such as gold and crude oil making triple digit returns since their 2001 bottoms, interest rates have remained tame; this can be seen in figure 2. It seems the low interest rate environment that has been giving stock investors little reason to invest outside the stock market may soon be ending. After recently breaking the 12 year downtrend line, rates have found support on them and are testing the neckline of a bullish upside down head and shoulders pattern. A breakout from this level would call for a minimum target of 7% on the 10 year T-notes rate. This level would be similar to the rate appreciation and rate level which preceded the 2000 market top. At that point, the commodity bull will have affected inflation and subsequently interest rates to the level where stock investors will be lured to a relatively high rate of return with theoretically zero risk, most likely a more attractive offer than stocks.

            Currently, we are still in a bullish environment, stocks are at new highs and the commodities driving stocks are in solid up trends. We will need to keep our eye on any breakout in yields so that we can have an early warning to when the party will end for stocks. For the moment, yields are not a problem, and higher highs will most likely be seen in the stock markets.

Figure 2 Chart by Metastock.com

Disclaimer

TradeSystemGuru.com obtains information from sources deemed to be reliable;
however, TradeSystemGuru.com. does not guarantee the accuracy of any of the
information provided. TradeSystemGuru.com makes no warranties, expressed
or implied, as to the fitness of the information for any purpose, or to results
obtained by individuals using the information. We may or may not be invested
in any investments cited above.

In no event shall TradeSystemGuru.com. be liable for direct, indirect, or incidental
damages resulting from the use of the information found on or distributed through
this website. TradeSystemGuru.com shall be indemnified and held harmless from
any actions, claims, proceedings, or liabilities with respect to the information
and its use. TradeSystemGuru.com does not make specific trading recommendations
or provide individualized market advice. All information provided is only to be
construed as opinions and to be used as an information service only. We encourage
investors to contact a registered securities representative prior to making any
investment or related decisions.