The Lead-Lag Report: Defensive Trade to Break?
Intermarket extremes are underway, and the cyclical trade is oversold. Could the deflation pulse begin to slow, or is fragility still high in stocks?
-- Michael E.S. Gayed, my father, in the second edition re-release of Intermarket Analysis and Investing
Below is an assessment of the performance of some of the most important sectors and asset classes relative to each other, with an interpretation of what underlying market dynamics may be signaling about the future direction of risk-taking by investors. The below charts are all price ratios, which show the underlying trend of the numerator relative to the denominator. A rising price ratio means the numerator is outperforming (up more/down less) the denominator.
For a full version of the Lead-Lag Report, click here.
LEADERS: EXTREME DEFENSIVE STRENGTH
Health Care (NYSEARCA:XLV) – Ratio Bubble?
Comments: Health care has gone vertical in terms of dramatic outperformance, which is reminiscent of early 2011 prior to the summer crash. While the trend in leadership remains in place, this looks to be an extremely crowded defensive trade. Among the defensive bear trades, this seems the most extended.
Consumer Staples (NYSEARCA:XLP) – Is Mean Reversion Coming?
Comments: Consumer staples leadership has been nothing short of stunning, and the ratio is now at pre-fall melt-up of 2011 levels. Could mean reversion soon kick in, causing cyclicals to lead and defensive sectors to break down? The trend of leadership remains up, but this could be an important thing to consider.
Utilities (NYSEARCA:XLU) – Continued Defensiveness
Comments: Much like consumer staples and health care, significant outperformance in utilities has been a part of the defensive posture within markets. The trend remains up, but signs for a reversal in the weeks ahead should be carefully watched for. Dividend sectors are rather expensive at these levels.
LAGGARDS: CYCLICAL OVERSOLD
Small-Caps (NYSEARCA:SLY) – Crash
Comments: Small-caps relative to large-caps have crashed since the start of the second quarter as the deflation pulse beat and risk-aversion increased internally within the market. The extremeness of the move might indicate some outperformance could occur, but for now the trend remains down.
Energy (NYSEARCA:XLE) – Massively Oversold
Comments: The cyclical trade has been a poor performer, with energy looking like small-caps in terms of a severe breakdown this quarter. Further weakness might be limited as the move appears to look more like capitulation than anything else. Certainly downward pressure on commodities more broadly does not help, but this may be a bit more than is warranted.
Industrials (NYSEARCA:XLI) – Collapse
Comments: Industrials have utterly collapsed in recent months as the deflation pulse grew stronger, and the trend remains firmly down. Poor guidance and continued concerns over overseas economic growth have caused many to underweight the sector. I would not be surprised, however, if some stabilization soon kicks in.
There are multiple crosscurrents underway. On the one hand, defensives have reached an extreme level of overbought leadership, which could reverse in favor of cyclicals. On the other hands, the bond market still does not appear to be convinced of reflation. More time is needed to see if a reversal that can hold will take place. My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual fund and separate accounts continue to play the deflation trade, but may be nearing a quick reversal into stocks in the weeks ahead.
Editor's note: This update is published every week exclusively for Minyanville, and is compiled by Michael A. Gayed, CFA, Chief Investment Strategist of Pension Partners, LLC.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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