By Michael A. Gayed
"After a storm comes a calm." - Matthew Henry
On December 27th here on MarketWatch, I wrote an article titled "Fall Melt-Up Ends, Winter Resolution Begins" in which I started the writing off stating the following:
"Its been an absolutely wild 2011 for the markets and me personally. After having been first featured here on MarketWatch for having correctly called the "Summer Crash" in some of my writings earlier this year (which expressed itself in August/September), and mostly getting the "Fall Melt-Up" right before the massive October rally began, its time to set my sights on what comes next during the Winter. Some may be disappointed by what the intermarket analysis I do suggests, but the implication is incredibly important from an investment-strategy standpoint. I believe we are at a major inflection point and that the volatile sideways action in the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY +0.26% will end in the next few months."
My initial feeling would be that another leg lower would assert itself, but following the first week of January, I dramatically altered my view as market internals themselves dramatically changed, and inflation expectations returned to markets in the blink of an eye.
I laid out the case in my Lead-Lag Report which comes out every week on Minyanville (love those guys as much as I love MarketWatch). As followers of my writings will note, my colleagues and I at Pension Partners are firm believers in the idea that conditions matter more than predictions from an asset allocation standpoint. What are the conditions that matter most for stock and bond investors? The direction of inflation expectations (not actual inflation).
Marc Faber of the Gloom Boom and Doom Report published an article of mine on Tuesday in which I argue that 2012 can be the year of "reflation" (similar to 2003 and 2009) and that the "bond bubble" everyone's been talking about may burst. I put "bond bubble" in quotes because I have no opinion about the semantics of whether the bond market is a bubble or not (technically hard to be a bubble in a traditional sense since holding to maturity means you get par).
Having said that, markets go through cycles, just like inflation/deflation waves. The amount of money that has gone out of stocks and into the bond market over the last year may have reached the apex of the cycle given how the intermarket relationships I highlight for Dr. Faber are reacting.
I wanted to provide another way of looking at why the bull move is just getting started and why the conditions continue to favor higher prices during the Winter Resolution, despite a very strong start to 2012.
Take a look below at the price ratio of the ProShares VIX Short-Term Futures ETF /zigman2/quotes/204693647/composite VIXY -5.86% relative to the ProShares VIX Mid-Term Futures ETF (VIXM). As a reminder, a rising price ratio means the numerator/VIXY is outperforming (up more/down less) the denominator/VIXM. For a larger chart, visit http://www.pensionpartners.com/marketwatch/vixyvixm020112large.JPG.
I use VIXY and VIX Mid-Term Futures ETF /zigman2/quotes/205971581/composite VIXM -0.86% instead of Barclays iPath S&P 500 VIX Short-Term Futures ETN /zigman2/quotes/202248173/composite VXX -6.03% and Barclays iPath S&P 500 VIX Mid-Term Futures ETN /zigman2/quotes/207730517/composite VXZ -0.94% (the more popular VIX instruments that are traded on exchanges) purely because I'm not a huge fan of Exchange Traded Notes (ETNs) relative to ETFs since they are unsecured debt instruments issued by banks.
I have annotated the chart to show the relevant changes in trends as it relates to the Summer Crash/Fall Melt-Up/Winter Resolution. What I want to focus on here is the complete collapse in the ratio, whereby shorter-term VIXY/VXX is severely underperforming medium-term VIXM/VXZ. In a way, this is one way of looking at the contango/backwardation that occurs in the VIX future curve.
Note that generally, a downtrend in the short/medium-term relative ratio is indicative of a bull market, while an uptrend is characterized by fear of an economic slowdown and deflation pulse. The bottom line here is that the trend is still firmly trending lower, and that even within the VIX future curves, there is a level of bullishness coming into the price of insurance. While I am certainly not suggesting a correction can't possibly come, my point is that in a world defined by probabilities and not certainties, the conditions continue to favor equities and anything risk-sensitive.
And so the Winter Resolution following the Summer Crash and Fall Melt-Up continues.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.