-- Green Day
With the correction in small caps over as those stocks attempt to push for new highs, all seems well yet again in markets. The S&P 500 (INDEXSP:.INX) is hovering around new all-time highs, while the average stock is flat to slightly up for the year. Much like a Pavlovian dog that salivates at the sound of a bell, it is almost considered a given that stocks are likely rally no matter what the Fed says, so long as the words "extended period of time" are stated.
There's a sticky problem though. This late into the cycle, bond yields are still extremely low and not really rising. Treasury Inflation Protected Securities (TIPs) have not broken out, signifying ongoing doubts about reflation. Housing continues to be stop-and-go, which in turn is dampening the wealth effect and consumer demand expectations. Put simply, while absolute price is anticipating a wonderful economic environment ahead, relative price is not.
In our 2014 Dow Award Winning paper An Intermarket Approach to Beta Rotation, Charlie Bilello and I showed that the utilities sector, when it's outperforming, tends to do so prior to VIX (INDEXCBOE:VIX) spikes and corrective environments for equities. Take a look below at the price ratio of the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) relative to the S&P 500 ETF (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/XLU is outperforming (up more/down less) the denominator/SPY. Note that utilities could still very well be in an uptrend, and that outperformance may be on the verge of returning.
That isn't exactly an encouraging sign. Historically, utilities since 1926 have outperformed prior to volatile junctures because "smart money" lowers beta exposure in anticipation of a deflation pulse. Utilities are an input in my firm's ATAC (Accelerated Time and Capital) models used for managing our equity and absolute return mutual funds and separate accounts. We are close to another defensive rotation. With many claiming that "sell in May and go away" has failed this year, it's worth considering that the only way to know if the saying holds true for 2014 is after October, when the "worst six-month period" for stocks is over. A correction may yet be lurking around the corner, and utilities seem to be anticipating that fragility still remains in the near future.
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