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The Lead-Lag Report: A Dramatic Shift to Risk-On

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This week's Lead-Lag Report shows a dramatic shift has occurred internally within markets, and risk-on returns in a potentially sustainable up move.

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"Man cannot discover new oceans unless he has the courage to lose sight of the shore."
-- Andre Gide

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: 2012 STARTS WITH IMPROVING RISK-ON SIGNALS

Health Care – Diverging From Other Defensive Areas



Comments: In last week's Lead-Lag Report, I noted that "2012 will likely be an important one for the sector given the elections as investors weigh the possibility that changes occur to the Health Care Reform Bill. This could result in the message from the sector's relative performance being muddled until voting takes place." The way that Health Care performed last week confirms this notion as Health Care diverged significantly from other "deflation/recession sectors" such as Consumer Staples and Utilities, both of which weakened substantially in a signal that markets are preparing for what could be a significant uptrend to come. In other words, with Health Care relative to the S&P 500 still above its 20-day moving average, it seems to be the "defensive sector of choice" if you want equity exposure but are still uncomfortable with broader beta risk.

Financials – The Start of Something Good?



Comments: I've noted before that the Financials sector appears to be in the process of bottoming, and that 2012 performance for equities likely hinges entirely on how Financials behave. Leadership in the sector would be indicative of an easing of financial stress, and a return of inflation expectations as bets increase on a steepening of the yield curve. Notice on the far right of the chart that the ratio appears to be in the early stages of an uptrend in a saucer-like technical formation. Should this pattern play out, I would argue a bet on markets is ultimately a bet on banks performing strongly. This alone is contrarian enough a stance to be possible with a potentially significant payout.

TIPS – The Ketchup Bottle?



Comments: The TIP/IEF price ratio is one way of seeing if inflation expectations are rising or falling within the bond market. When the ratio is trending higher, it means bets are occurring on rising prices ahead. When falling, deflation is the concern as nominal bonds become favored. While the trend looked to be headed down as 2011 ended on a deflationary note, the spike last week in outperformance is a very bullish sign. Much like a ketchup bottle which suddenly coats the plate after repeated attempts, it appears as though bets on reflation/inflation significantly increased last week within the bond market. This is a very bullish sign for equities should strength continue, as it suggests that the environment is more favorable toward risk-on positions in stocks.

LAGGARDS: A DRAMATIC SHIFT

Consumer Staples – Pause Turns to Significant Break



Comments: Consumer Staples, which was a strong sector performer last year, started 2012 off hovering around 0.26 which seems to have served as a relative resistance point. It appears now that the pause in performance that I referenced last week has ended, with a new downtrend potentially starting for the sector. This is very important from a sentiment standpoint, as it suggests that defensiveness is coming out of markets aggressively. Continued weakness into the end of this week would indeed be a very positive sign for the bulls, as volatility declines and animal spirits possibly return with a vengeance.

Utilities – From Income to Capital Appreciation?



Comments: Perhaps the most encouraging sign for the bulls in terms of 2012 sentiment is the complete collapse that occurred in the relative performance of Utilities to the S&P 500. Because the Utilities sector is interest-rate sensitive, weakness in the sector suggests investors are anticipating higher interest costs to come. This likely would be the case if inflation expectations return to markets as they appear to be doing. Continued weakness in the sector could signal higher equity prices as the sentiment pendulum swings away from income-oriented investments, and into capital appreciation ones.

Bonds – The Trend Emerges...Down?



Comments: I noted last week that "should the price ratio break down, it could result in a significant re-allocation away from bonds and new money flows into equities. A few more weeks are needed though to be comfortable with such a position." It appears that last week's move into equities is suggesting that a downtrend may finally be starting in the relative performance of bonds to equities. The coming week is crucial, but 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.

Conclusion

A dramatic improvement internally within the markets took place last week, as defensive sectors, and bonds sold off, while inflation-sensitive areas outperformed. There appears to be a growing risk-on sentiment occurring very suddenly, in what could be a very bullish sign for the stock market in the near-term. Confirmation this week is likely crucial, as animal spirits look ready to return.

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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