The Lead-Lag Report: Looks and Smells Like a Correction
Odds of a correction are at their highest level this year as the bear trade returns. The test for the Spring Switch and reflation theme is at hand.
-- Charles Caleb Colton
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
LEADERS: POSITIONING FOR A CORRECTION
Financials (XLF) – A Critical Moment
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. Poor jobs data on Friday makes leadership in the near term for financials questionable. I believe leadership will likely remain, but the sector is very close to flipping from leader to laggard. Next week should confirm which way the sector is likely to go, and in turn, whether the long-awaited stock market correction is here.
Consumer Staples (XLP) – Defensiveness Returns
Comments: I noted last week that "more time is needed to confirm a change in trend to leadership given end-of-quarter window dressing." It appears that defensiveness is back, suggesting a period of weakness is likely for broader beta as strength in low beta consumer staples comes back into vogue.
Health Care (XLV) – Big Move
Comments: Last week I stated that "a new trend may be at hand, but given end-of-quarter window dressing, more time is needed to confirm." (See Gold Likely to Cede Leadership to Equities Into 2012.) The strength has been substantial as bearishness creeps back in and the bear trade returns. Strength in health care relative to the market is a negative sign as it suggests investors are anticipating a period of high volatility to come.
LAGGARDS: HARD TO BE A BULL HERE
Energy (XLE) – Still No Love
Comments: While I initially thought there was a possibility for strength to return to energy, the sector continues to weaken against the broader stock market as oil prices themselves decline. The ratio, however, is nearing October ratio lows and may stage a period of strength in the coming weeks. Watching the sector closely will be important to see if the global oil trade comes back into favor. For now, though, the sector remains a difficult one to capture outpeformance in.
Small-Caps (IWM) – Small-Cap Breaks Down Further
Comments: While I initially thought a period of strength could come back in small-cap stocks, the ratio has significantly broken down, suggesting that investors are not comfortable with beta risk just yet. This in turn is not a positive sign for risk sentiment and suggests further declines may be ahead consistent with the message of utilities, health care, and consumer staples.
Treasury Inflation Protected Securities (IPE) – Deflation?
Comments: The IPE/TLH 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 ratio has broken its 20-day moving average, signaling there is a deflation pulse beating beneath the surface of the bond market following Friday's jobs report. This remains a very important relationship to watch for the risk-on/off question.
While market internals looked positive in last week's Lead-Lag Report, a significant change to market internals happened last week, suggesting that the odds of a correction are at their highest level so far this year. If stocks can hold in the face of deteriorating market internals, further gains likely are ahead. Until then, defensiveness appears to be the right stance in the near-term.
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.
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