The Summer Surprise Of 2012, Or The Great Realization

| About: Vanguard FTSE (VWO)

"All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident." - Arthur Schopenhauer

Following the Summer Crash of 2011, Fall Melt-Up, Winter Resolution, and Spring Switch series of writings I have put out since last year, it is now time for my next major "call" on markets. I do think the "Spring Switch" out of bonds and into stocks was finally flipped in early June given the panic bond yields were signaling then. Bond prices spiked in a way not seen since after Lehman, while stocks continue to yield more than 10 year Treasuries (NYSEARCA:IEF). Many companies are in fact raising dividends, which is at complete odds with the negative narrative and feeling that we are in the midst of another 2008 repeat.

Stocks have continued to act resiliently, and I believe reflation expectations are likely to get more and more entrenched in investor psyche. Companies have better balance sheets than most government, more growth, and now yield better income than income producing "risk-free" bonds. The fear trade got to the point that market internals behaved as if an economic collapse already occurred, as defensive sectors relative to the S&P 500 reached ratio levels not seen since the end of 2008. As inflation expectations return independent of "stimulus disappointment" from last week's Operation Twist extension by the Fed, the Summer Surprise will likely be that reflation persists and that we see an end to the "end of the world trade" which made investors forget that return of principal in the bond market is not the same as return of purchasing power.

The end of the world trade also sent valuations in many defensive, slow-growth sectors to levels which are unjustified. By way of example, the utilities (NYSEARCA:XLU) sector has little top line growth, and yet has a richer price to earnings ratio than technology (NYSEARCA:XLK). Growth simply is not valued because of the negative narrative, and story over Europe playing out like 2008 all over again. This is not just a sector phenomenon though. Many emerging markets which still have strong growth have lower valuations than developed economies which are struggling to keep the engine running.

Take a look below at the price ratio of the Vanguard Emerging Markets VIPERs ETF (NYSEARCA:VWO) relative to the S&P 500 (NYSEARCA:IVV). As a reminder, a rising price ratio means the numerator/VWO is outperforming (up more/down less) the denominator/IVV.

Click to enlarge

Weakness in Emerging Markets has been consistent since the peak all the way back in 2010. Yet, these economies are growing at a far faster pace than the U.S., while easing their own respective monetary policies in many cases. And yes - the P/E of emerging markets on average is lower than developed economies, which is in turn a function of the global fear trade and negative narrative.

If indeed expectations turn, emerging markets should be direct beneficiaries, which in turn makes commodities stage a comeback. Given the continued bearishness in the face of a stock market which has better income than bonds, and better growth in emerging markets than developed ones, the markets may surprise the vast majority of scared money which will in turn get scared that it is wrong in thinking that the future could turn out just fine, or at least less worse than originally thought.

Disclaimer: Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.