The Lead-Lag Report: Bonds Leading, Emerging Market Stocks Outperforming
Two big trades on a rotational basis are forming. For equities, it is emerging markets; for bonds, it is long duration.
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.
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LEADERS: NEW OUTPERFORMERS EMERGE
Materials (NYSEARCA:XLB) – Continuation
Comments: Materials have staged a nice comeback since August, in line with strength in emerging markets and a rotation to global cyclical trades. The trend for now remains higher, and a re-acceleration in China could provide more fuel for alpha momentum in the weeks ahead.
Energy (NYSEARCA:XLE) – Leading
Comments: Energy has been showing some signs of strength recently and appears to be an early leader, consistent with materials outperforming and emerging market stocks getting a bid. This appears to be an early move thus far as oil hovers around its current level.
Emerging Markets (NYSEARCA:GMM) – Early and Confirmed
Comments: Emerging markets appear very much to be stabilizing after severe underperformance that has taken place thus far in 2013. Now outperformance does appear to be legitimately underway, with significant alpha potential into the end of the year. This appears to be where money is positioning for the fourth quarter.
LAGGARDS: DEFENSIVE BOTTOMING?
Utilities (NYSEARCA:XLU) – Reversal Coming?
Comments: Utilities were badly hit as yields rose due to Fed tapering talk, reaching extremely oversold levels. The trade has gone sideways in recent weeks as bond yields have stabilized. Should we re-enter a true risk-off period whereby money seeks safety in dividend plays, the ratio could move higher.
Consumer Staples (NYSEARCA:XLP) – Bottom Coming?
Comments: The peak in consumer staples occurred just before the taper spasm broke down the yield play. Since then, the ratio has fallen as money shunned the income trade. While the trend remains lower, one should be on the lookout for a reversal to come as earnings come in and potentially disappoint equity bulls.
Bonds (NYSEARCA:TENZ) – Bonds Getting Love
Comments: With the Fed not tapering and an extended US stock market, leadership in bonds relative to US stocks appears to be kicking in after severe underperformance all year. US stocks and US bonds have priced in reflation which does not exist. This implies that the ratio should be at a higher level than where it is now.
US markets look increasingly vulnerable as bonds lead and defensive sectors appear on the verge of bottoming. Against that backdrop are emerging market stocks, which have been outperforming nicely since September. If you need to be an equity investor, emerging markets offer good potential. If you have the ability to be flexible, bonds offer opportunity for a re-allocation into defensiveness.
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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