Was That the Bottom? Beyond the Summer Crash of 2011

Includes: IVV, SPY, TLT, XLP, XLU, XLV
by: Michael A. Gayed, CFA

“Moving fast is not the same as going somewhere.” - Robert Anthony

Since June 8, I've been stressing in many of my articles here on Seeking Alpha that the stock market was on the verge of a “great re-adjustment” in which bonds would outperform equities in a very sudden and swift way. I called this the “summer crash” because I believed equity investors were not listening to what the bond market had been screaming since February as yields began trending lower. That, in conjunction with the disconnect of the “bull market” being led by defensive sectors, was an indication of serious denial about the building negativity toward beta underneath the market's surface.

I believe a good chunk of the crash may be over, the question now is what happens next.

To analyze where we go from here, I think it's worth looking at the very same price ratio charts I pointed to in the June 8 article where I first argued for a significant and sharp decline in the stock market. My intention here is to use underlying leadership trends to determine what Mr. Market is saying about future prospects for risk-taking and trend direction.

As a reminder, a price ratio shows the underlying trend and sentiment of market participants by plotting the price of one investment relative to another. A rising price ratio means the numerator is outperforming the denominator. Note that outperformance is not a call on absolute price direction. If the numerator goes down, but down by less than the denominator, the ratio still rises.

The Sector Warnings

My interests lie in looking at inter-market relationships to see if there are distortions, mixed messages, or a consistent theme. Take a look below at the relationship of defensive sectors relative to the S&P 500 (NYSEARCA:IVV) (NYSEARCA:SPY) in recent months. As I stated in the June 8 article, I focus on utilities (NYSEARCA:XLU), healthcare (NYSEARCA:XLV) and consumer staples (NYSEARCA:XLP) sectors because they can be early indicators of a market correction/bear market. After all, these low beta sectors tend to outperform in declining markets because of their lower average beta/inelastic products and services.

Healthcare - 2008 All Over Again - Not Quite Out of the Woods

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Comments: I noted in my June 8 article that healthcare is “leading in a way that is reminiscent of the second half of 2008.” Notice that the ratio did fall off a bit on news of certain cutbacks in government spending on the sector, but has once again spiked and is above its one month/20 trading day moving average. This remains a bearish sign for markets.

Consumer Staples – Healthcare's Twin – Hello My Name is Spike

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Comments: I asked the question before: “How can it be that a defensive sector so strongly outperforms in a bull market?” The relative ratio spiked in a way not seen since the dark days of Lehman. That trend may continue, particularly should things worsen in Europe. It's worth noting here that like healthcare, the ratio bottomed in February.

Utilities – The Bond Market's Twin – Back in Time

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Comments: Utilities are a great sector to watch for an early tell on the bond market because of how interest rate sensitive the sector is. Notice that the ratio is now almost completely back to where it was pre-QE2, and the trend for now appears to remain higher.

Long Bonds (NYSEARCA:TLT) – the Ratio Catch Up – the Great Re-Adjustment

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Comments: This was the biggie. In the June 8 piece, this is what I wrote:

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.

The combination of the collapse in yields despite the S&P downgrade of U.S. debt and the sharp collapse in equities resulted in the Great Re-Adjustment I have been referring to, sending the ratio sharply higher. The main thing I want to point out is the similarity of the spike to how the ratio behaved in the early days of the Lehman collapse. The implication here is that the relationship may very well continue to rise should the European crisis further spiral out of control.

I specifically bolded in my prior article that “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.” The fact that what rallied the most in this collapse was the long-end of the Treasury curve says that the bond market is incredibly afraid of deflation/recession.

While a good chunk of the crash may now be over, the conditions for further weakness in risk asset prices appear to still be very much intact. Although equities may mount a bounce-back rally, I believe things will only truly improve if the bond market gives confirmation through rising and not falling yields.

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

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