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The Lead-Lag Report: Financials Hurt Correction Odds


Last week's stress test results and reaction to it by market participants dramatically altered the possibility of a near-term correction. Markets now look likely to continue headed higher, with financials leading the way.

The importance of money flows from it being a link between the present and the future.
-- John Maynard Keynes

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 that 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.


Financials (XLF) – Vertical

Comments: I have continued to stress the importance of financials in recent Lead-Lag Reports for the bulls given that any kind of sustained outperformance would be seen as a sign that financial conditions are easing and that reflation is expected globally thanks to central banks around the world trying to avert another crisis. Financials relative to the market went vertical following the Federal Reserve's stress test results last week and may be signaling another leg higher is coming as a result.

Junk Debt (JNK) – Credit Spread Contraction Continues

Comments: The above ratio is one way of seeing if credit spreads are narrowing (uptrend in the ratio) or widening (downtrend in ratio). I've noted before that leadership in financials should ideally be confirmed by leadership in junk debt relative to nominal Treasuries. The trend up is healthy and is happening within an environment of rising yields, which is a positive development. The Fed wants to force credit spreads to narrow, and easy monetary policy increases the odds of that happening.

TIPS (TIP) – Reflation

Comments: The TIP/IEF price ratio is one way of seeing if inflation expectations are rising or falling within the bond market. When the ratio is trending higher, it means bets are occurring on rising prices ahead. When falling, deflation is the concern as nominal bonds become favored. The spike up coincides with excitement over last week's stress test results and signifies bond investors believe in reflation.


Europe, Australasia, and the Far East (EFA) – Still Not Exciting

Comments: EFA continues to want to underperform, seemingly because the US dollar (UUP) is gaining some overall strength. The ratio never really outperformed in a massive way, making any continuation of weakness likely short-lived and shallow. For now the US remains the developed equity market of choice.

Emerging Markets (VWO) – Weakness and Correction?

Comments: I noted last week (see The Lead-Lag Report: Market Offers Signs of a Correction):

Emerging Markets now do appear to be headed for a potentially more meaningful period of weakness, with the ratio trading firmly below its 20-day (one trading month) moving average. It is unclear how severely the ratio could underperform magnitude-wise given how poorly emerging markets performed last year. At least in the near-term, emerging markets look to be lagging the US.

That trend seems to have picked up steam as the US continues to be favored by global investors.

Long Bonds (TLT) – Steepening Just Getting Started

Comments: Long bonds (20+ years) relative to shorter duration 7-10 year Treasuries weakened on better economic data in the US. A downtrend in the above ratio means that money is favoring shorter-duration bonds, which is bullish because it suggests inflation expectations are getting repriced into the Treasury yield curve. Last week's stress test results broke the ratio in an important way, as further weakness in the long-end of the Treasury curve looks likely.

Conclusion? Last week's stress test results and reaction to it by market participants dramatically altered the possibility of a near-term correction, as markets now look likely to continue headed higher, with financials leading the way.

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.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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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