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Critical Juncture: Correction, or New Highs?


Either this latest move higher sucked in new bulls right before a correction, or new highs will soon follow.


Give me a one-handed economist! All my economists say, "On the one hand...on the other."
-- Harry S. Truman

In my latest Buzz (subscription required), I alluded to the idea that markets are very much on the fence here in terms of which way to go. In late September, I began highlighting "corrective hesitation" given renewed strength in the "bear trade" following the announcement of QE3 that signaled the deflation pulse was starting to beat once again beneath the market's surface.

Markets fell the most since June last week, and have rallied in a stunning way in just the last few days. Is a breakout imminent, or is this yet another false move designed to suck in the "nouveaux bulls" who failed to participate on the upside and now have complete faith in the "Bernanke Put"?

This is quite a challenging juncture. While I maintain that the "Fall Catalyst of 2012" (new all-time highs in the Dow) is likely in the next three months, absolute price is acting as if it wants that to happen considerably sooner. And yet, full blown confirmation has not yet occurred in terms of intermarket trends.

Take a look below at the price ratio of the Consumer Staples ETF (NYSEARCA:XLP) relative to the Consumer Discretionary ETF (NYSEARCA:XLY). As a reminder, a rising price ratio means the numerator/XLP is outperforming (up more/down less) the denominator/XLY.

This is one way of gauging market sentiment. Consumer Staples (need) tends to outperform Consumer Discretionary (want) when money is concerned about a slowdown in the economy, coming volatility, or a correction. In other words, when money gets defensive, it favors "inelastic" companies that are less sensitive to the economic cycle. Conversely, when money wants to position more aggressively, it positions into those stocks more sensitive to consumer confidence and increased spending. Note that the trend in the ratio tends to coincide with market sentiment. When rising, markets have acted in defense mode. When falling, the opposite happens as risk taking increased.

Notice the move off of the mid-September level, which is around the time I started sounding the alarm on intermarket deterioration. The trend appears to be losing steam, but has not yet broken down in a way suggestive of a true risk-on period ahead (at least not yet). It is as if we are in some strange bull/bear tug of war equilibrium where there is little conviction in either direction. Our ATAC models used for managing our mutual fund and separate accounts remains defensive, but could position aggressively into equities if enough improvement occurs within the market shortly.

A bit more time is needed, but I believe we are at an important juncture. A resolution internally within the markets means the corrective period has passed and new highs become ever more likely much faster than I originally thought. However, should deterioration return, markets could conceivably fall meaningfully to adjust for that.

The next few days are critical, and my next Lead-Lag Report should help to get a sense of what happens next. [Editor's note: Here is the previous Lead-Lag Report .]

Correction or new highs? On the one hand...on the other.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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