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Michael Gayed: What Happens Next Will Determine Whether Stocks Enter a Melt-Up or Correction


We're approaching a critical juncture for the market's bulls and bears.

The imagination imitates. It is the critical spirit that creates.
--Oscar Wilde
This is looking more and more like an important period for both bulls and bears for the second quarter. Following what has been a melt-up in emerging markets relative to US small caps, money is trying to position for the next major move to come.  If leadership is real in emerging economies, it will last more than a few weeks. It is not a trade for 2014, but rather a theme. Against that backdrop have been bonds, which, despite a bit of a sell-off, remain resilient in the face of encouraging ADP numbers and defensive sectors that are still holding strong.
If Friday's payroll report comes in ahead of expectations, then the combination of hope for demand-pull inflation combined with potential stimulus from China pushing commodity prices higher could mean that stocks overall need to push forward.  Inter-market movement, which is sensitive to inflation expectations, is improving. One of the keys will be the behavior of utilities, which may be about to flip from leader to laggard. Utilities tend to outperform during deflationary pulses and lag during reflationary periods. Charlie Bilello and I addressed this in our 2014 Charles H. Dow Award-winning paper "An Intermarket Approach to Beta Rotation."

If inflation expectations are about to rise, another leg higher would be likely.  A breakdown, however, would be damaging and bond-friendly. Take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) relative to the PIMCO 7-15 Year Treasury Index (NYSEARCA:TENZ). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/TENZ. Note that the ratio has been holding in a consolidation pattern.

This is one way of tracking inflation expectations, similar to utilities. If this breaks down, a correction may be coming. If it turns higher definitively, then the emerging market sector will likely be what leads equities higher. At tomorrow's Market Technicians Association Symposium, which Minyanville will be covering live, traders will be reviewing trend lines, oscillators, and technical indicators.  All this works to some degree, but conditions that nudge risk-taking will still be key for asset-class movement. Inflation expectations can be an important tell on investor behavior.  If demand pull and cost push are about to work together at the same time, then the weeks ahead could result in a continuation of the uptrend. However if payroll data disappoints, it could be a difficult time for Nouveaux Bulls.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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