From Summer Crash to Fall Melt-Up?
Here's why we are on the verge of a very real risk-on/melt-up moment in equity prices into the end of 2011.
-- Arthur Schopenhauer
That's right folks – it's time to get crazy. After having called for a deflation pulse in February, silver top in April, summer stock market crash in June, and gold top early September (all of which are dated articles available here on Minyanville as well as other financial websites I write for), I am now going the complete other way. I think we are on the verge of a very real risk-on/melt-up moment in equity prices into the end of the year.
My objective in looking at markets and making macro calls is not to give my opinion, but rather to listen to the message of the markets. I look internally within sectors and externally across asset classes to see if there is a consistent message underlying market dynamics. Inter-market analysis and investing is something that in many ways is in my blood – it's an approach my father was a big fan of when he worked with the legendary Bob Farrell in the late 1980s. He even wrote a rather large book about it in the early 1990s (one of the first books I ever read on investing).
I want to make it clear that I still believe that there is a deflation pulse that's alive and well, but sentiment is stunningly bearish. Every single commentator on major media outlets is now super negative. Where were they when I was writing about this as early as February? Everyone seems bullish on defensive sectors/high dividend paying stocks. Now? Really? It just seems to me that the sentiment swung so wildly negative when in reality these tensions were building since February, and few are considering the real contrarian trade here, which is that equities rally despite deflation fears.
This should not come as a big surprise. Japan has undergone deflation for two decades, and the Nikkei has had a number of 20%+ moves during that period. So with that said, let's see if there's a bottom-picking move that can be identified here. Take a look below at the price ratio of the Russell 2000 ETF (IWM) relative to the S&P 500 ETF (IVV). As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/IVV.
Now clearly the trend in the relative performance of small-cap high beta stocks has been down relative to large-cap low beta stocks. What I want to highlight though is the level that the price ratio is at now. The decline experienced is very reminiscent of the latter half of 2008, when the "event" of Lehman's demise sent global markets down in a panic. The level we are at now on the ratio takes back two years of outperformance in small-cap stocks, all the way to mid-April 2009 levels. All this without an "event" actually having happened. Instead it's been fear of an event.
What if the market pulls a fast one and starts to price in not the event happening, but the event NOT happening? It seems to me that this is a strong possibility, and I will be stressing in a number of my articles going forward this main point. Of course, an event may indeed happen, making the recent ratio weakness in beta names justified. However, if it does not, we may see the mother of all rebound rallies into the end of the year.
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