Why This Correction May Be Short-Lived

“Leadership is, among other things, the ability to inflict pain and get away with it — short-term pain for long-term gain.” – George Will

Markets have been notably more volatile over the past two weeks given a slew of macro news that has woken the bears from their slumber following the best first quarter in many years for risk assets.

The initial wave of selling was sparked by the release of Fed minutes two weeks ago that suggested the Fed was not in favor of initiating Quantitative Easing 3.

Only days after, investors began making bets once again that the Fed would initiate further stimulus as jobs data in the U.S. came in soft. Investors then turned their attention overseas. The Bank of Japan kept policy unchanged, deciding not to expand its asset-purchase program, while China’s growth rate declined more than expected.

The biggest worry, though, remains Europe — particularly Spain, as its 10-year yield neared the panic level of 6%. Concerns relate to Spain’s economy and its government, which seems unable to control spending and debt, which in turn is greatly increasing the odds of another eurozone bailout. Data show that Spanish banks borrowed a significant amount from the European Central Bank in the past month, signaling deep financial stress. This has largely pushed investors in risk-off mode as Treasury yields fall in response to the flight-to-safety trade.

I remain bullish on equities, which I believe are in the midst of a 2003/2009-like environment. However, as I noted to followers of my company’s Twitter handle (@pensionpartners), our ATAC models sensed a deflation pulse and positioned us largely into risk-off mode. I do think we’re likely in a mini-correction here.

What makes me say “mini?” Take a look below at the price ratio of the iShares MSCI Europe Financial Sector ETF (NASDAQ:EUFN) relative to the S&P 500 (NYSE:IVV). As a reminder, a rising price ratio means the numerator/EUFN is outperforming (up more/down less) the denominator/IVV.

Click to EnlargeEuropean Financials strongly outperformed in January following the significant period of weakness the group suffered through in 2011. I noted in prior writings that the strength of European Financials was a very bullish sign for markets. Following January, though, the ratio flat-lined and began lagging starting in mid-March.

While the ratio is still in a downtrend, it’s nearing the ratio low of very early January, which could be hit any time in the coming weeks. If that occurs in the near future and the ratio begins to trend up on a resumption of strength in the sector, then this decline in broader risk assets likely is not going to be that deep.

Given that this entire crisis is driven by European Financials, it would make sense that the market follows the sector’s overall relative performance. In other words, a relative uptrend in European Financials is more likely to create an absolute uptrend in markets. And given that the ratio is very possibly nearer to the end of its weakness than the beginning, markets could reverse in a way faster than the bears think.

The Lead-Lag Report is provided by Lead-Lag Publishing, LLC. All opinions and views mentioned in this report constitute our judgments as of the date of writing and are subject to change at any time. Information within this material is not intended to be used as a primary basis for investment decisions and should also not be construed as advice meeting the particular investment needs of any individual investor. Trading signals produced by the Lead-Lag Report are independent of other services provided by Lead-Lag Publishing, LLC or its affiliates, and positioning of accounts under their management may differ. Please remember that investing involves risk, including loss of principal, and past performance may not be indicative of future results. Lead-Lag Publishing, LLC, its members, officers, directors and employees expressly disclaim all liability in respect to actions taken based on any or all of the information in this writing.

Subscriber Sign in