The Fall Melt-Up Of 2011, Or The Great Surprise

Includes: IVV, SPY, XLP, XLU, XLV
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

I first used the above quote, a personal favorite of mine, in my June 8 article here on Seeking in which I argued for a Summer Stock Market Crash of 2011. Looking at the growing number of articles since then, you'll notice that I was fairly aggressive in thinking this would happen based on intermarket analysis and studies I conduct at my firm Pension Partners, with a good amount of the following articles actually having in the subject line “Summer Crash of 2011.” The Crash happened starting in August, and there has been substantial volatility and pain since then for investors everywhere.

I believe there is a growing possibility that the mother of all counter-rallies is coming very shortly. My reasoning for this, just like my reasoning for the Summer Crash article on June 8, has nothing to do with gut feeling or emotional responses to volatility. Followers of my articles will note that I look at markets from a relative perspective to see if there is a consistent message occurring internally within the stock market, and externally across asset classes. My objective is not to dictate my personal opinion as much as to interpret what markets may be saying. It is this approach that led me to call for a deflation pulse in February when Marc Faber of the Gloom Boom and Doom Report first published an article of mine, the Silver top in April, the Summer Crash in June, and the Gold top earlier this month (all of these major calls are dated and viewable here on Seeking Alpha).

The Sector Signals

In the interest of being consistent, I'd like to a use a similar methodology to what led me to call for a summer crash to begin with, but this time put it in perspective in both time and justification. Doing this involves looking at price ratio trends. As a reminder, a rising price ratio means the numerator is outperforming (up more/down less) the denominator.

Healthcare (NYSEARCA:XLV) – 2009 All Over Again?

Click to enlarge

Comments: February was the month that marked the beginning of the end for reasons to be bullish on equities this year, as defensive sectors such as healthcare (XLV), consumer staples (NYSEARCA:XLP) and utilities (NYSEARCA:XLU) all began to slowly show outperformance relative to the S&P 500 [[(IVV]]/SPY). It was also the same month that the long bond began to lead as well. In the case of healthcare, notice that the ratio is hovering around March 2009 levels now, and that the trend itself appears to be tired. Despite continued volatility, healthcare relative to the market is not showing convincing strength in recent weeks, while at the same time at a two year high. That is bullish from a contrarian standpoint.

Consumer Staples (XLP) – Healthcare's Twin

Click to enlarge

Comments: Consumer staples looks very similar to the ratio behavior of healthcare, but more accentuated. Again, the ratio is hovering around early 2009 levels, and has failed to trend convincingly higher post the August spike. The ratio is at a potential extreme level now, especially when you consider that a Lehman event has not occurred, while strength in the group has behaved like it has. If the magnitude of the strength is not justified because an event actually has not happened, then from a contrarian standpoint, the sector's strength may be finished. That's bullish.

Utilities – The Bond Market's Twin

Click to enlarge

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 .... Down?

Click to enlarge

Comments: The “Great Re-Adjustment” occurred in August as bonds spiked relative to equities to catch up to the message of the defensive sectors of the equities market. The latest spike occurred on the week that was the worst for the Dow Jones Industrial Average since August 2008 (with Operation Twist announced at the same time). The spike stopped right around mid-2009 levels, and the overall strength has behaved like Lehman has happened, when in reality it has not.

What is the bottom line? Defensive sectors have all stopped convincingly, making new relative highs against the S&P 500 despite horrible news and continued fears overseas. Redemptions have come fast and furious in the hedge fund community, and everyone I hear out in the media is bearish. Where were these people in June when I started writing about the summer crash? People are bullish on dividend stocks and defensive sectors now? Really? Same story with bonds here – it could be that the Operation Twist announcement was the blow-off peak.

Here is the big idea: Defensive sectors and the bond market have behaved as if a Lehman-like event has occurred. But the reality is that it has not. That is not to say that it still can't, but it seems to me that the market has discounted such an event in the near-term. The great surprise is that the market may discount the possibility that Lehman won't happen, and if it does, then prepare for the mother of all stock market rallies into the end of the year.

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. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.