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The Lead-Lag Report: Reflation and Melt-Up Returns?

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While the eurozone crisis continues to intensify, market internals are nearing levels where a melt-up becomes more and more likely as reflation expectations return.

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MINYANVILLE ORIGINAL

I haven't had the time to plan returning to the scene because I haven't left it.
-- Mick Jagger

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: CYCLICAL TRADE LOOKS GOOD

Materials (XLB) – Bottoming



Comments: Materials have flat-lined in the past month and a half after bottoming relative to the S&P 500 in mid-May during the mini-correction. This is fairly impressive given continued concerns over slowing growth and Europe. Leadership appears likely in the weeks ahead.

Energy (XLE) – Sharp Comeback



Comments: The ratio of energy to the stock market has spiked since late June as tensions rise over Iran and oil more broadly recovers. Momentum seems likely to continue given how depressed the ratio was to begin with.

Treasury Inflation Protected Securities (TIP) – Reflation Returns?



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. Notice how sharply the ratio collapsed and hit support levels not seen since the post-October 3 low. A recovery may be in order, which would be a bullish sign for markets overall.

LAGGARDS: ROTATION IS COMING

Consumer Staples (XLP) – Turned Back at Resistance



Comments: Consumer staples have been unable to break through price ratio resistance, which is a bullish sign from a risk-sentiment standpoint. Staples has been a place for money to hide in the equity markets, and a breakdown means risk-on sentiment could return relatively quickly.

Consumer Discretionary (XLY) – Downtrend Remains Entrenched



Comments: As I have stated before, "[O]f all the sectors I track, the most bearish on a relative basis appears to be the consumer discretionary sector, which has rallied significantly more than broader stock markets have since late 2008. Weakness in the sector is not necessarily a bad sign, as it simply may mean that other sectors like financials are taking its place as market leader." Not much has changed, particularly now as Oil returns to strength.

Small-Caps (IWM) – Support in Sight



Comments: Small-caps have given back the outperformance spike that occurred at the very end of June, as market internals began deteriorating since July 5. Still, the ratio is nearing support, which if held is likely a bullish sign.

Conclusion? Market internals are nearing a tipping point, with defensive areas once again reaching extremes, which makes another melt-up in risk assets likely. It is worth noting that the potential for outperformance in TIPS is perhaps the most bullish argument now for a move back into risk-assets, as reflation expectations return in the midst of crisis mode in Europe.

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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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