Have Stocks Gone Too Far Too Fast, or Not Far Enough?
The question that matters isn't whether markets have gone too far too fast, but if the conditions we're operating in are suggesting we haven't gone far enough.
It seems like the new mantra now after the strong start to 2012 is that the move has gone "too far too fast." I certainly can understand the feeling given the unrelenting internal strength in markets and the pervasive fear still surrounding a default of Greece. It feels like last year never happened and that volatility has returned to more "normal" levels (one of the conditions of my "Winter Resolution" idea following the Summer Crash and Fall Melt-Up). Has anything changed really in terms of the global economic landscape? Is the stock market justified at these levels?
I address this in-depth in an article coming out next month which will be published by Marc Faber of the Gloom Boom and Doom Report. I will also be addressing this tonight live on Bloomberg Rewind with Matt Miller as I co-host for the hour alongside Ed Dempsey. Let's try to answer the question of the move higher in stocks being justified from the perspective of not what actual prices are doing. Let's stop thinking in terms of a prediction for market levels. Instead, let's think about markets from the standpoint of what my colleagues and I believe matters the most – the conditions we're operating in.
The conditions under which an asset class operates in is far more important than a prediction of what that asset class will do. The most important condition that drives asset class returns? The direction of inflation expectations. When rising, it's better to be in stocks relative to bonds. When falling? Bonds are more favorable than stocks.
One way of seeing if inflation expectations are rising or falling is by looking at the price ratio of Treasury Inflation Protected Securities (TIP) relative to nominal bonds (IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.
I analyze the direction of the ratio in my weekly Lead-Lag Report (an exclusive here on Minyanville I put together every week). Notice how uptrends occur in favorable environments for the stock market, and downtrends when stocks have a hard time doing well. The trend is the key here, and the persistence of that trend. When TIP outperforms IEF, it means inflation protection is being favored over non-inflation protected bonds. Investors would cause leadership in TIP to occur when expectations for future inflation are rising. The far right of the chart shows what appears to be the very early stages of outperformance in TIP relative to IEF. The conditions are early, the trend is early, and should it persist, then the stock market S&P 500 (SPY) has only just begun its ascent. Sure we could pull back and pause, but so long as the market is sensing reflation, those very declines might be shallow and only met with more buying.
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