Why The Rally Is Real And Just Getting Started

 |  Includes: IEF, TLT
by: Michael A. Gayed, CFA

"Nothing ever becomes real till it is experienced." - John Keats

As I've stressed in several of my articles here on Seeking Alpha before, conditions are more important than predictions. Several studies show that environmental factors dictate the likelihood of a certain type of behavior more than anything else. If you want the vast majority of people to cheat on their diet, put them in an environment surrounded by delicious food where several stimuli make the odds of losing discipline high. So too, environmental factors as it relates to markets dictate the kind of behavior investors likely exhibit.

The Winter Resolution idea I've floated around here on Seeking Alpha and several other sites following the Summer Crash and Fall Melt-Up appears to be playing out. I believed that the volatile sideways action of last year would resolve itself and end, while correlations and volatility drops and a trend asserts itself. Following the first week of this year, the conditions dramatically altered in favor of stocks, as the Winter Resolution turned into an uptrend. The reason for this is pure and simple - a return of inflation expectations which market participants are signaling is coming through various intermarket relationships.

I explore this in-depth in my next piece which Marc Faber of the Gloom Boom and Doom Report will be publishing next month. In essence, I make the case that 2012 could end up being the year of reflation much like 2003 and 2009, and that bond yields are likely to rise substantially from these levels. This after having correctly identified the deflation pulse as early as February last year. I will be attempting to work this into my live co-hosting segment on Bloomberg Rewind tonight with Matt Miller (tune in and provide feedback).

So let's focus on the primary driver of asset class returns in terms of the way my colleagues and I think about markets: inflation expectations. Take a look below at the price ratio of the iShares Treasury Bond 7-10 Year Bond ETF (NYSEARCA:IEF) relative to the iShares Treasury Bond 20+ Year ETF (NYSEARCA:TLT). As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/TLT.

click to enlarge

Click to enlarge

Think of this ratio as a way of tracking whether the yield curve is flattening (downtrend), or steepening (uptrend). I want you to notice how an uptrend tends to coincide with a period of strength for stocks and weakness for bonds in terms of the period 2009 to Flash Crash 2010, QE2 Start 2010 to February 2011, and now. Yes - the ratio peaked out early last year and collapsed during the Summer Crash as TLT substantially outperformed.

But notice where we are now. The ratio now appears to be staging an uptrend. When would an uptrend occur? When expectations for future growth and inflation are increasing. The ratio is very far away from prior levels and may be in the early stages of an uptrend. What this means is that the equity rally looks to not only be real, but also early as the environment appears to be favoring the return of inflation expectations. And that's the kind of environment stocks can rally in.

Disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized advice. The opinions herein are not personalized recommendations to buy, sell or hold securities.