The Summer Crash of 2011, Or the Great Re-Adjustment

by: Michael A. Gayed, CFA

“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

Allow me to start off this article by stating that I have no intention of being an alarmist. However, there are enough distortions occurring which indicate the possibility of a significant decline in the stock market.

Followers of my articles note that my interests lie in inter-market relationships. Whether it's looking at sectors, stocks, bonds, commodities, etc., I believe in presenting data in a rational way for readers to make up their own minds as to the implications of my analysis. Looking at these types of relationships led me to publish the article titled "Was that the Top for Silver?" just a few days before the massive decline occurred.

The Crash of 1987

To this day, there is no single reasonable explanation as to what mechanically caused the October Crash of 1987, in which the Dow Jones Industrial Average (NYSEARCA:DIA) fell over 22% in a single day. While it is unclear what sparked the decline (much like it is unclear what resulted in the Flash Crash of 2010), the clearest explanation has to do with the Stock/Bond ratio leading up to Black Monday. That ratio reached an extreme which was quickly undone in the crash. Yields at the time were pushing toward double digit highs, while the stock market was on fire. This means that bonds fell in price and so significantly underperformed rising stocks at the time that the Stock/Bond relationship reached what I would call a ratio bubble. The 1987 crash was mean reversion at its finest, as that ratio got undone.

The Sector Warnings

I bring this up because I want to emphasize that when ratios and relationships get out of whack, it is only a matter of time that the market adjusts to get those very same relationships back to historical levels. Take a look below at the relationship of defensive sectors relative to the S&P 500 (NYSEARCA:IVV) in recent months. For those who follow my work, you are well aware of my focus on the utilities (NYSEARCA:XLU), healthcare (NYSEARCA:XLV) and consumer staples (NYSEARCA:XLP) sectors as early indicators of a market correction, since these sectors only tend to outperform in declining markets because of their lower average beta/inelastic products and services.

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Healthcare – 2008 All Over Again
Comments: Healthcare has crushed the market in terms of outperformance this year, leading in a way that is reminiscent of the second half of 2008. Remember, this has occurred in what otherwise appears to be a very strong market.

Consumer Staples – Healthcare's Twin

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Comments: The same situation is occurring here – how can it be that a defensive sector so strongly outperforms in a “bull market”?

Utilities – The Bond Market's Twin

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Comments: Utilities are an important sector to watch. Why? Because leadership in utilities tends to coincide with leadership in bonds as an asset class. As a matter of fact ...

Long Bonds (NYSEARCA:TLT) – the Ratio Catch Up

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Comments: This is crucial – notice how the ratios of utilities (XLU) and long bonds (TLT) tend to follow a similar pattern. Outperformance periods tend to coincide well with each other. However, while bonds have only begun to outperform stocks, they have only done so at a minimal pace, and not to the same extent as defensive sectors. In other words, the magnitude of the outperformance of bonds relative to stocks has not tracked the magnitude of outperformance in defensive sectors noted above. I would argue that the ratio should be closer to 1 instead of 0.74 because of the strength in defensive sectors.

How does this ratio get to 1? Either through significant strength in bonds/weakness in yields, or through a sudden and very sharp decline in stocks. While the 1987 stock/bond ratio is what caused the crash because of how far out of whack the relationship of the two asset classes got at the time, it is the ratio of defensive sectors and tepid outperformance of bonds which is now what Mr. Market must resolve. And as much as I want to believe that financials (NYSEARCA:XLF) will turn around soon...

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... the longer Mr. Market does not pay attention to the significant and on-going weakness in financials, the more violent the decline is likely to be as a wake-up call to the overall weakness in the financial sector.

The bottom line? I believe we are likely to face a mean reversion moment in the relationship of stocks to bonds, whereby stocks decline in a major way as an adjustment to the leadership of defensive sectors. The bond market is clearly afraid of something big given that yields are falling in the face of the end of the Fed's QE2 program. The stock market has not yet noticed what the bond market is screaming. And the bond market tends to be right much more often than the stock market.

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

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