The Lead-Lag Report: You Bet It's Bullish
This week's Lead-Lag Report shows a continuation of the bullish sentiment occurring underneath the market, with some noticeable changes in the way the bonds are pricing in reflation.
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.
A full version of the Lead-Lag Report can be viewed by clicking here. Below is a shortened version.
LEADERS: SIGNS OF INCREASED RISK-TAKING
Financials (XLF) – Continuation of the Return to Reflation
Comments: In the last Lead-Lag Report, I stated that "recent outperformance could feed on itself if investors begin to get the feeling that the worst may indeed be over, and reflation is the thing to position for going forward." With many bank and financial earnings now announced, it is encouraging to see that the outperformance of the sector continues despite results that may not have been blockbuster but at least were not disastrous given last year's operating environment. Leadership in Financials remains one of the most important indicators of a favorable environment for equities.
Technology (XLK) – IBM and Microsoft Cause Trend Reversal?
Comments: I wrote last week that "if earnings in the sector surprise just enough, the ratio could certainly move higher in the weeks ahead." Much of the comeback in recent strength is directly attributable to investor reaction to earnings released from Microsoft (MSFT) and IBM (IBM). Given that the two make up about 17% of the XLK ETF, its possible that the big money that moved into those stocks continues to buy other Technology names in the near future, causing further strength in the sector.
Junk Debt (JNK) – Credit Spread Contraction Ahead?
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. Last week was the first week of this year where a nice move within the Junk Debt market occurred relative to nominal Treasuries, which saw yields rise as money moves out of "risk-free" paper. A further trend higher would be quite bullish as it would suggest credit stress is easing.
LAGGARDS: CONSISTENT WITH A BULLISH ENVIRONMENT
Consumer Staples (XLP) – Weakness Continues
Comments: A healthy bullish environment is one where defensive sectors such as Consumer Staples continue to underperform broader equity averages. The trend lower continued last week. I suspect there is a possibility that the sector tries to stage a bit of a comeback in relative terms, but clearly the trend remains down as investors chase higher beta stocks and take on more beta risk. Weakness in the group likely can continue is a sustainable way as money continues to re-allocate away from defense and into offense.
Long Bonds (TLT) – Yield Curve Steepening Ahead?
Comments: Long bonds (20+ years) relative to shorter duration 7-10 year Treasuries appear to finally be breaking in favor of the downside. 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. You can clearly see how the ratio trended higher as the Summer Crash of 2011 took hold. I noted last week that the "coming week should provide more insight on whether the yield curve begins to send the same message as various sectors of the stock market that the environment is bullish and conducive towards risk-taking." With long bond yields not only rising, but rising at a faster pace than shorter duration bonds, the yield curve may be starting to steepen on anticipation of a period of economic growth ahead.
Bonds (IEF) – Re-allocation to Stocks Likely
Comments: Last week I stated that "should the trend continue lower, this likely means a lot of money could be put to work into equities away from bonds. This remains a bullish sign for risk-taking in the near-term." The trend lower in the ratio means that for the first time in a long time investors seem to be more persistent in favoring equities over fixed income. This suggests a re-allocation away from bonds and into stocks may be underway despite continued concerns over deflationary pressures.
Continuing with my theme of the Winter Resolution, it does appear that the right things are outperforming and that the environment remains favorable for equities. Despite many stating that volume is low and that this is not a real rally, market internals have dramatically changed from last year. Should such trends continue, 2012 may end up being the year of reflation similar to 2009 and 2003.
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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