One of our challenges is trying to discern not only what the dominant theme is for the economy but how it will show up in the financial markets.

We have an assortment of views and one of them is that growth is powered alternately by capital and consumer spending. When U.S. growth is driven by consumer spending then the offsetting Asian theme will focus on capital spending and vice versa.

Let’s consider the trend through the previous decade. The peak for the Nasdaq in 2000 marked the top for U.S. capital spending and as interest rates plummeted the markets shifted from a capital spending theme over to a consumer spending theme. Initial strength came from the freeing up of consumer income through mortgage refinancing but as time passed home prices started to rise which expanded consumer spending through home equity draw downs. The expansion of U.S. consumer spending led to an offsetting expansion in Chinese capital spending as factories were built to produce new consumer goods.

With the benefit of hind sight it is all too clear that the previous decade’s trend was driven by post-Nasdaq consumer spending with an emphasis on real estate and home renovation. Now for the challenging part.

If we were to pick one stock to serve as the ‘poster child’ for a theme predicated off of U.S. consumer spending, home renovation, and rising real estate prices it would probably be Home Depot . Yet the chart below of HD along with the ratio of crude oil futures to the CRB Index shows that HD’s share price spent the entire decade trending lower.

The point is that the economic theme was dominated by U.S. consumer spending while the markets theme was focused on contracting valuations for large cap U.S. stocks, rising commodity prices, and, perhaps most intently, on energy price strength.

Going forward we expect U.S. growth to come from capital spending as cash-heavy companies ramp up takeover activity and business expansion. Asian growth should be focused on consumer spending through rising incomes. Our recurring thought is that the markets trend will be set by those sectors benefitting from an increase in capital spending which means that we continue to favor ‘tech’ as a broad theme with a lean towards sectors such as the autos that combine technology to reduce energy use with rising Asian consumer demand.

There are times when the equity markets rise with a stronger dollar and there are also times when stocks rise with higher bond prices. However... this is not one of those times.

There are two main ‘drivers’ these days behind rising equity prices- a weaker U.S. dollar and falling bond prices.

Below we compare the U.S. Dollar Index futures with Hong Kong’s Hang Seng Index. The argument is that while the U.S. equity markets declined through the entire second quarter the dollar’s weakness that began in early June helped to swing the trend back to positive. The chart shows that once the dollar peaked in early June the Hang Seng Index began to recover.

Below we show the SPX along with the spread between 10-year and 3-month Treasury yields. The argument here is that the last two peaks for the SPX were made just after the yield spread reached a peak close to 3.8%. In theory if the SPX were to follow the rising trend line set by linking the January and April peaks a slow recovery by the yield spread back up to 3.8% could see the SPX at 1300 or even 1350 some time during the second half of this year.

Below is a comparison between the SPX and the combination of the U.S. 30-year T-Bond futures and the U.S. Dollar Index.

If the equity markets rise when the dollar is weaker and also rise when the bond market is trending lower then the SPX should trend inversely to the sum of these two markets. The point is that a decline in the sum below around 203 would suggest that the equity market’s trend has shifted from bearish during April and May to neutral during June and July back to bullish- perhaps for August and September.