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The Lead-Lag Report: Energy Returns to Strength

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This week's Lead-Lag Report has two notable changes with small-caps now lagging and energy now leading. While a pause in strength may be at hand, overall reflation conditions remains positive.

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Energy and persistence conquer all things.
--Benjamin Franklin

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, please click here.

LEADERS: HESITATION, BUT BULLISHNESS REMAINS

Financials (XLF) – Holding On



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. The trend remains positive as reflation expectations continue to get priced in, and is a bullish signal for markets more generally. A potential slowdown may be at hand, however, now that markets have been greeted with news of a bailout for Greece.

Consumer Discretionary (XLY) – Oil Now a Drag



Comments: I noted in last week's Lead-Report that "I remain unconvinced that it will continue to outperform longer-term given the length of time under which it has done well to begin with." With Oil (USO) now nearing $105 a barrel, it would make sense for consumer stocks to begin to underperform now, with this week likely key to overall direction.

Energy (XLE) – Oil Pushes Sector Up



Comments: I noted last week that "energy's weakness may soon be ending, but more time is needed to confirm. The sector remains challenging to generate alpha from given uncertainty over Iran and the direction of oil prices more generally. There are likely better, clearer sectors to position into for long or short trades." The spurt of strength coincides with Iranian tensions and the embargo enacted on Britain and France. Oil prices now do appear to be trending higher, which is potentially a bullish reason for the stock side of the energy equation.

Junk Debt (JNK) – Credit Spread Contraction Continues



Comments: The above ratio is one way of seeing if credit spreads are narrowing (uptrend in the ratio) or widening (downtrend in ratio). I've noted before that leadership in financials should ideally be confirmed by leadership in junk debt relative to nominal Treasuries. The trend up is healthy and is happening within an environment of rising yields, which is a positive development. The Fed wants to force credit spreads to narrow and easy monetary policy increases the odds of that happening.

LAGGARDS: MORE OF THE SAME, BUT WITHOUT ENERGY

Small-Caps (IWM) – High Beta Breakdown?



Comments: Small-caps relative to large-caps have now weakened and crossed below their 20-day moving average. A downtrend may potentially assert itself, however I suspect the ratio could simply flatten out at these levels as investors digest eurozone news and focus on oil prices going forward.

Long Bonds (TLT) – Steepening Has More to Go



Comments: Long bonds (20+ years) relative to shorter duration 7- to 10-year Treasuries weakened on better economic data in the US. A downtrend in the above ratio means that money is favoring shorter-duration bonds, which is bullish because it suggests inflation expectations are getting repriced into the Treasury yield curve. Continued weakness suggests a favorable environment for risk-taking persists.

Conclusion?

The two biggest changes from last week's Lead-Lag Report are in high beta small-cap stocks now being weak, and leadership in energy. With Greece now out of the way (for now), it appears to be high oil prices that markets will focus on next. However, so long as inflation expectations continue to rise, stock outperformance to bonds likely can continue.

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.

Twitter: @pensionpartners
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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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