The Lead-Lag Report: V-Formation Failures

Minyanville

During market declines, the relative-strength method gives an early clue about future leaders in the market.
-- Michael E.S. Gayed, my father, in the second edition re-release of Intermarket Analysis and Investing

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.

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LEADERS: STUBBORN DEFENSIVENESS

Financials (XLF) – Sideways Continues

[More from Minyanville.com: Minyanville's T3 Weekly Recap: Precious Metals Lost Luster in Sharp Sell-Off ]

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Comments: Financials have been somewhat of a boring sector as of late, making little headway in terms of both outperformance and underperformance since the start of the year. If this has simply been a pause and leadership returns, it might coincide with reflation expectations and a slowing of the deflation pulse. However, it might be worth questioning exactly why financials have not outperformed meaningfully this year despite all of this "money printing" underway through QE.

Consumer Staples (XLP) – Is Mean Reversion Over?

[More from Minyanville.com: Chart of the Day: Health Care, Consumer, and Utilities Sectors Rising to Unsustainable Levels? ]

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Comments: Consumer staples leadership has been nothing short of stunning, and the ratio hit pre-fall melt-up of 2011 levels. The mean reversion that I argued was likely in the last Lead-Lag Report seems to have taken place, but it is not yet clear if a definitive break has occurred. A bit more time is likely needed to confirm.

Utilities (NYSEARCA:XLU) – Continued Defensiveness

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Comments: Much like consumer staples and health care, significant outperformance in utilities has been a part of the defensive posture within markets. The trend remains up, but signs for a reversal in the weeks ahead should be carefully watched for. Dividend sectors are rather expensive at these levels.

LAGGARDS: FAILED V FORMATIONS

Small-Caps (NYSEARCA:SLY) – Head Fake

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Comments: Small-caps relative to large-caps have just undergone a massive head fake, forming a V formation before cracking hard again. This could be quite problematic as it indicates risk sentiment is switching somewhat violently beneath the market's surface.

Industrials (NYSEARCA:XLI) – Collapse Continues

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Comments: Industrials have utterly collapsed in recent months as the deflation pulse grew stronger, and the trend remains firmly down. Poor guidance and continued concerns over overseas economic growth have caused many to underweight the sector. I would not be surprised, however, if some stabilization soon kicks in.

Treasury Inflation Protected Securities (NYSEARCA:IPE) – Now What?

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Comments: The IPE/TENZ 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. Note that the ratio has been falling, indicative not of inflation but rather deflation concerns. Whether low rates cure low rates is unclear just yet, but the deflation pulse remains intact until intermarket trends say otherwise.

Conclusion

Many V-formations appear to be failing after a decent period of short-term strength in the cyclical trade. My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual fund and separate accounts remain defensive given the direction of inflation expectations. More time is needed to see if a change will soon come, but the V breakdowns seem to be quite telling about underlying market sentiment.

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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