The Lead-Lag Report: Did the ECB Change Everything?
This week's report shows some underlying improvement after last week's ECB lending, but skepticism remains internally within markets.
Investors should start with a view of skepticism. They should become intellectual investors rather than emotional investors. They should be careful, and they should be skeptical.
-- Arthur Levitt
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.
A full version of the Lead-Lag Report can be viewed by clicking here. Below is a shortened version.
Leaders: Santa Looks... Different
Utilities -- Holding Pattern Not Broken Yet
Comments: So long as investors continue to pile into high-dividend paying sectors like utilities, real market strength cannot return in a convincing way. Healthy bull markets are not led by defensive sectors which are not cyclically sensitive. The utilities sector's price ratio remains elevated as uncertainty persists. Should the trend reverse in a definitive way, it could signal a major bull move is to come, as money flows out of dividend stocks and into growth ones. However, this signal has not flashed just yet despite last week's strength in beta.
Financials -- Key to the Bull
Comments: Financials have been a heartbreaker all year, with multiple false starts in what has otherwise been a massive downtrend and period of underperformance. It could very well be that the European Central Bank's efforts will change the sentiment toward banks, bringing back a real period of strength in the sector.
Any kind of a new bull move likely needs to be led by the financials sector given that the decline in large part is due to financial stress. The recent strength, should it continue, is likely the most powerful reason to believe in a bull move, but additional data points are needed to confirm. Removing the possibility of a Lehman-like shock through increased money printing likely will result in a very real move higher for stocks at some point next year.
TIPS -- ECB Abruptly Changes Deflation Prospects?
Comments: Before the ECB's lending last week, it appeared that the above ratio was on the verge of a very significant downtrend as deflation fears were becoming more and more entrenched in the market. The ratio violently turned back upward as inflation expectations came back on the influx of new money in Europe. Further strength is needed to see how justified the move is, particularly given the upcoming bond auctions in Italy, which appear to still be problematic given that Italy's 10-year once again spiked to over 7%. Inflation expectations are crucial for equities to be in risk-on mode.
Laggards: Grinch in Red?
Energy -- False Comeback?
Comments: The extreme weakness in energy got undone last week with a spurt of leadership, causing a V-like move off of the ratio level of around 0.54. While this can be seen as a bullish surprise, it is not entirely unexpected given the mean reversion potential I noted before. While it may be tempting to position into the energy sector now, the trend still does not appear to be your friend in the group given that the ratio was unable to cross its 20-day moving average. Failure to continue strength in the coming days suggests that weakness will reassert itself.
Consumer Discretionary -- Early Downtrend
Comments: Independent of last week's strength in broader beta, the consumer discretionary sector still appears to be in the very early stages of a period of relative weakness. With the incredible discounting retailers have been pushing through the holidays and the general sense of a consumer retrenchment coming, the sector does not appear to be the best way to bet on a rising market environment, and it could easily undo all of the outperformance that occurred in 2011 next year should global growth continue to slow. Elevated oil prices likely will result in a change in purchasing behavior in the months ahead, serving as a drag on the sector's potential to outperform in a meaningful way.
Long Bonds -- Second Failure to Break New Highs
Comments: For a second time now long bonds (20+ years) relative to shorter duration 7-10 year Treasuries have failed to break through resistance. This is bullish should the trend continue, as it signals that the yield curve may be steepening again. This steepening likely would be the result of expectations for a reflationary period to hit the global economy, which would be an environment conducive toward equities. However, the breaking of the ratio may not be justified given what appears to have simply been a relief rally on the ECB's lending program to European banks. Likely this becomes an incredibly important ratio to watch in the first two weeks of January.
Markets appear to be headed in the right direction for risk-on improvement, but the fact that the many of these ratio changes occurred in a light volume week and the direct result of a sigh of relief stemming from the ECB's lending likely means more data is needed to see if monetary intervention really did change underlying market conditions. Santa may indeed be the Grinch in disguise, so caution still remains warranted.
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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