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Summer Surprise? Continued Reflation as Stocks Melt-Up


The all-time lows in Treasury bonds of early June marks the moment the Spring Switch happened.


All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
-- Arthur Schopenhauer

Spring is now officially over, and it's time to talk about the "Summer Surprise." I had been arguing that following the Summer Crash of 2011, Fall Melt-Up, and Winter Resolution, that a "Spring Switch" was in order as a "Great Reallocation" out of bonds and into stocks takes hold. My reasoning for this was related to panic low yields in bonds, which would ultimately force money into taking risk. In early April, I began making the case for a "mini-correction" in stocks which could prove to the world that stocks would be a resilient asset class. At the time, I argued that resiliency would only further the case for the Switch to be flipped.

I do believe that the all-time lows in Treasury bonds of early June marks the moment the Spring Switch happened, but will only know with hindsight if money starts to flow into stocks again in the coming months. Markets in many ways "pre-panicked," acting as if a Lehman-like event had already occurred when in reality it did not (I made the case for this idea on Bloomberg on June 4). The most recent melt-up in stocks, I believe, is due to the realization by market participants that, in fact, such a Lehman-like event did not take place.

I believe now comes the "Summer Surprise," which is the idea that stocks continue to rally as reflation persists and the negative narrative fails to come to fruition. It is, in essence, an end to the "end of the world trade" that has happened worldwide based on various intermarket relationships. Take a look below at the price ratio of the Financials Select Sector SPDR ETF (XLF) relative to the Utilities Select Sector SPDR ETF (XLU). As a reminder, a rising price ratio means the numerator/XLF is outperforming (up more/down less) the denominator/XLU.

Financials tend to outperform when the yield curve steepens, which happens when inflation expectations return to markets. Utilities, on the other hand, tend to outperform when the yield curve flattens. A rising ratio coincides with a favorable environment for equities, while a falling on means the opposite. Notice that a turn appears to be happening here, as financials begin to perform better on a comparative basis. A continuation of this trend would be consistent with reflation expectations taking hold, and a continuation of a rise in stocks.

And what a Summer Surprise it would be given low volumes, the negative narrative, and love for bonds...

Twitter: @pensionpartners
No positions in stocks mentioned.

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